Britain's pound is march's surprise European currency outperformer, for now

British Pound Outshines European Currencies in March Amid Rate Surges

Pound's Performance and Market Dynamics

By Alun John and Amanda Cooper

LONDON, March 16 (Reuters) - The pound is Europe's surprise currency market winner of the Iran war-induced market turmoil, supported by surging British short-term interest rates, even if, analysts say, it still looks vulnerable medium-term.

It has appreciated against every major European currency so far in March, including the positively oil-exposed Norwegian crown, and jumped 1.4% on its nearest neighbour the euro.

For sure, the big currency-market winner of the war so far has been the dollar, and the pound has fallen 1.7% against that.

But the broader outperformance of the pound, one of the most actively traded global currencies, has grabbed attention because it stands in contrast to its usual trading pattern.

Typically, sterling weakens when equities fall - as they have since the war began - and recently it weakened when longer-dated government bond yields rise, as has been the case this month.

Short-Term Interest Rates Drive Sterling

All About Short-Dated Rates

"The pound should be lower, the trade deficit's getting higher," said Jordan Rochester, head of fixed income and currency strategy at Mizuho.

However, he said it had been rising because British interest rates had jumped. "The problem for foreign exchange is interest rates sometimes matter and sometimes they don't. And now they matter."

Britain's two-year gilt yield has risen by a monster 60 basis points so far in March, on fears that higher energy prices will send inflation higher. This means that instead of anticipating Bank of England rate cuts this year, a hike is more likely.

German two-year yields have risen roughly 40 bps, a lot, but less than in Britain. Rate moves have also been less pronounced in Switzerland, Norway and Sweden, helping the pound against their currencies.

The gap between one-year euro and sterling overnight interest rate swaps has been in particular focus, and moved 20 bps in the pound's favour from late February to March 16.

Relative rises in yields typically support a currency, because investors receive a better interest rate.

These moves have dwarfed everything else.

Strategists' Insights

UBS currency strategist Benjamin Jarrett noted three factors driving the pound in the shorter term: short-dated interest rates - and sterling appreciates when they rise; longer-dated interest rates - sterling weakens when they rise due to worries about the economic outlook, and overall risk sentiment in markets.

"Obviously two and three are definitely going against sterling, it's just the front-end rate story totally dominated the last two weeks," he said. "The repricing higher in Bank of England expectations has been so much more aggressive than anywhere else."

Positioning and Political Factors

Positioning Unwind

The pound's gains against the euro have been particularly stark. If the euro's fall against the pound in March so far holds, that would be its biggest monthly fall since November 2024.

It is also nearing its lowest level since August.

Barclays currency strategist Lefteris Farmakis said that last month, traders had bet the sterling would fall against the euro on speculation British Prime Minister Keir Starmer would be forced out. Now, with focus shifting elsewhere, "that political premium in the pound is unwinding".

Eurasia Group now assigns a 65% chance that Starmer is ousted this year, down from 80%.

Medium-Term Vulnerabilities

But analysts struggle to see the outperformance continuing.

Either the war comes to an end, shorter-dated rates fall back, and with them the pound, or the longer it lasts, the more worries about Britain's finances start to weigh on the currency.

"Given the negative growth shock we are arguably seeing from this energy shock, I think you have to think about this fiscal risk premium argument coming back as a driver," UBS' Jarrett said.

(Reporting by Alun John and Amanda Cooper; Editing by Dhara Ranasinghe and Pooja Desai)