Political tension in the UK has grown, with resignations and talk about a leadership change adding pressure on Prime Minister Keir Starmer. This has increased uncertainty about future fiscal policy.
The Pound has weakened, and political instability is linked to this move. Policy plans from possible successors remain unclear.
Commerzbank expects the market has not fully priced these risks. It forecasts EUR/GBP will rise in the coming weeks.
The article was produced using an artificial intelligence tool and reviewed by an editor.
With the noose slowly tightening around Prime Minister Starmer, the political situation in the UK is becoming a major factor for currency markets. The recent resignation of the Chancellor over fiscal disagreements has severely weakened the Prime Minister, and we question whether he can remain in office for much longer. This situation is decidedly negative for the pound.
The problem is twofold: political uncertainty itself is rarely good for a currency, and it is completely unclear what fiscal policies any potential successors might implement. UK 10-year gilt yields have already widened their spread over German bunds by 15 basis points just this week, showing that bond traders are already demanding a higher risk premium. This is a clear signal that instability is being priced into UK assets.
We all remember the gilt market crisis of late 2022, which showed how quickly investor confidence can evaporate when fiscal credibility is questioned. The current infighting and lack of a clear economic plan echo the start of that turmoil, a sharp contrast to the stability that followed the 2024 general election. This historical parallel suggests that any further missteps could trigger a disproportionately large market reaction.
Despite the pound’s recent slide, we believe these political risks have not yet been fully reflected in market prices. One-month implied volatility in EUR/GBP options has climbed to 8.9%, its highest level this year, indicating that traders are now bracing for larger price swings. However, the spot price has not yet broken decisively higher.
Given this, we continue to expect higher EUR/GBP levels in the coming weeks. Derivative traders should consider positioning for further sterling weakness, for instance by buying EUR/GBP call options to profit from a move higher with limited risk. The uncertainty creates a clear directional bias against the pound.
This view is compounded by the latest flash Manufacturing PMI, which unexpectedly fell into contraction territory at 48.9 for May. A weakening economy provides a poor backdrop for a political crisis, making the pound particularly vulnerable to further shocks. We see little reason to be optimistic about sterling until there is a clear resolution to the leadership question.
