The British pound strengthened on Wednesday, appearing to rebound as part of a conventional rally amid a warming risk sentiment. However, this actually reflects the market's reassessment of the UK's vulnerability in the "high oil prices-high inflation-high interest rates" chain. With expectations of eased tensions in Iran, the tail risk of an energy shock has shrunk. The market began to unwind the dollar longs and the hawkish bets on the Bank of England that were established due to the previous war, benefiting the pound.
Industry Chain Transmission
For UK assets, the transmission path of Middle East conflicts typically starts with energy. Although the UK is not the most vulnerable European economy, as an energy importer, its currency and interest rate markets remain quite sensitive to rises in crude oil and natural gas prices. When geopolitical conflicts push up oil prices, the market quickly worries about the resurgence of imported inflation, thereby raising expectations for continued tightening by the Bank of England, which suppresses the outlook for the real purchasing power of the local currency. The dollar previously benefited from this, partly because it is the preferred global safe-haven currency and partly because the US has relatively more buffering capacity in terms of energy supply.
The change on Wednesday was that this chain was temporarily reversed. Although Brent crude is still above $100 per barrel, it has somewhat receded. The market believes that if tensions between the US and Iran indeed cool down, the risk premium on oil prices may not continue to accumulate rapidly. In this case, the marginal pressure of imported inflation that the UK faces is reduced, and the previously heightened expectations for Bank of England rate hikes also decline. The pound's rebound is precisely a price reaction to this compressed risk premium.
Competitive Landscape
From a relative performance perspective, the current pound trading is not simply "risk on, pound up." Danske Bank strategists point out that if the Iran situation eases, the pound might weaken against the euro; if the situation escalates and risk appetite is severely impacted, the pound may underperform. This indicates that the pound faces a dual constraint: on one hand, the retreat of the dollar is favorable for the pound's rebound against the dollar; on the other hand, if the Bank of England's rate hike expectations fall too quickly, the interest rate differential supporting the pound against other European currencies could also weaken.
This also explains why UK gilt yields and the pound can present a seemingly inconsistent combination. The yield on UK two-year gilts fell by 5.5 basis points to 4.322%, indicating the market is trimming bets on further Bank of England rate hikes; yet, the pound rose against the dollar because the retreat in dollar safe-haven demand is happening faster. In other words, the recent pound strength is more about "a weaker dollar than the pound" rather than "UK fundamentals stronger than all counterparts."
Subsequent Trading Framework
Looking ahead, the market will closely watch Trump's speech and whether US policies towards Iran further soften. If tensions continue to ease, the pound may maintain a recovery trend against the dollar. However, whether the uptrend is sustainable depends on whether energy prices can fall further and whether the Bank of England's path remains on "limited tightening" rather than "a dovish turn." If Brent oil prices stay high, the risk of UK inflation remains hard to completely eliminate, potentially limiting the pound's upside. For investors, the current situation seems more like a phase of rebalancing dominated by geopolitical expectations with an assist from interest rate logic, rather than a clear, singular macro trend.
