The Pound’s New Year Rally: What’s Really Driving Sterling, and What Comes Next

The pound has started 2026 on a strong footing, touching its highest level against the dollar since October 2021. On the face of it, this looks like an impressive rally from the lows of 2025. The obvious question, though, is whether this marks the start of a genuine turnaround in the fortunes of sterling and the UK economy, or whether something else is going on.

Budget Relief Brings a Lift in Confidence

There are, to be fair, a number of clear positives for the pound as we move through January. November’s Budget, while still attracting criticism in places, has primarily been greeted with a palpable sense of relief. Markets had braced for a much harsher package of tax rises, and the fact that the outcome was less severe has helped to draw a line under months of harmful speculation. For businesses and consumers alike, that clarity matters. As uncertainty fades, confidence has begun to stabilise, and in some cases improve.

Early post-Budget data are starting to reflect this shift. The S&P flash UK PMI composite output index for January rose to its highest level in two years, pointing to a robust pickup in business activity. Monthly GDP for November also surprised sharply to the upside, rising by 0.3% month-on-month, while retail sales continued to advance strongly into December. Taken together, these figures suggest that pent-up activity may be starting to come through as the fog around fiscal policy lifts.

Calmer Gilt Markets, But Inflation Complicates the Rate-Cut Story

Financial markets have echoed this calmer tone. UK gilts have steadied, with bond yields falling to their lowest levels in more than a year as concerns over the public finances ease. That reduction in risk premium has been supportive for sterling. At the same time, however, inflation has re-entered the conversation. December’s CPI print surprised on the upside at 3.4%, the first increase in five months. Just weeks ago, rapid declines in October and November, alongside Budget measures to cap regulated energy and transport costs, had raised the prospect of inflation returning to target as early as the second quarter, opening the door to as many as two interest rate cuts this year.

That narrative has since softened. Expectations for easing have been pushed back, with markets now seeing June as the most likely timing for the first cut. Ironically, that shift has lent the pound some additional support on the prospect of higher interest rates for longer. From here, developments in wage growth will be crucial, as a resulting cooling in services inflation would help resolve the final, stubborn stage of disinflation, the so-called “last mile”.

The Dollar Does the Heavy Lifting

Yet it is hard to escape the conclusion that sterling’s recent strength owes at least as much to the other side of the trade. Much of the move has been driven by a weaker US dollar, as part of a broader “sell America” theme. Markets have been grappling with renewed geopolitical volatility as President Trump escalates, and then retreats from, a series of confrontational positions. The dollar hit a low point during the height of the Greenland episode, when threats of 25% tariffs on NATO allies, and even military force, rattled investors. While that particular drama faded after a more measured tone emerged, it was quickly replaced by fresh concerns: an approaching government shutdown, and increasingly explicit tolerance from the White House for a weaker dollar.

Fed Pushback Offers the Dollar a Reprieve

Yet the dollar has found some relief in recent days following a surprisingly hawkish Federal Reserve meeting. Fed Chair Powell, under pressure after legal threats from the Department of Justice, was keen to stress that the case for further rate cuts remains weak. With the US economy still running hot and inflation proving persistent, policymakers appear unconvinced that monetary policy is overly restrictive as it stands.

Why Sterling Lags Its G10 Peers

One clue that it is the dollar, rather than sterling, doing much of the work can be found elsewhere in the G10 space. The pound has underperformed against several peers, most notably the euro. That likely reflects a still-challenging investment backdrop. While sentiment towards the UK has improved, and borrowing costs have come down, both are rebounding from very unfavourable positions. Furthermore, in a world where economic and political clout increasingly matter, the euro area benefits from scale and institutional heft. The UK, by contrast, remains more exposed to global shocks and is less able to shape them.

Political Tests Lie Ahead

There are also domestic risks on the horizon. Local elections in May represent the most serious political test yet for Prime Minister Starmer. A strong showing by populist parties, whether Reform UK on the right or the Greens on the left, could see his position as leader of the Labour Party challenged. This would unsettle markets that have so far taken comfort from his relative policy pragmatism and fiscal restraint compared to the more fringe elements of UK politics.

A Rally Built on Fragile Foundations

All of this leaves the pound in an uncomfortable position. Against the dollar, it looks resilient. Against the wider currency complex, the picture is far less compelling. Sterling’s recent gains rest on fragile foundations, heavily dependent on the actions (and missteps) of others. That is not an ideal place for any currency to be, and it helps explain why recent optimism on the pound, while understandable, should still be tempered in the months ahead.