The British pound has shown surprising strength during recent geopolitical turmoil, ranking as the second-best performing currency against the U.S. dollar since the start of March, according to analysis from Bank of America. That resilience is striking given the set of headwinds facing the U.K. economy this year, and the bank says the drivers are more about market positioning and terms-of-trade effects than a clear improvement in domestic fundamentals.
BofA highlights a notable regime shift in the behavior of the GBP/USD exchange rate. For roughly two decades GBP/USD moved in close step with the bank’s GBP risk-sentiment indicator - a composite measure that blends the first principal component of GBP risk premia, FX volatility, the U.K. term premium and U.K.-U.S. rate differentials. That linkage, the bank reports, broke down in mid-2024 and has not reasserted itself since, with GBP/USD diverging persistently from the underlying risk-sentiment signal.
More recently, the current geopolitical shock has had global reach rather than being concentrated on the U.K., which has pushed domestic policy concerns into the background. Earlier this year investors more commonly expressed U.K.-specific worries through EUR/GBP, but that pair has become less prominent as markets responded to wider international developments.
BofA identifies two principal mechanisms supporting the pound. First, the U.K. has experienced a relatively favourable terms-of-trade shift compared with many other G10 currencies. The bank’s work shows that the combined standard deviation move in terms of trade and positioning has been a key element behind GBP performance in recent weeks, creating what the analysts describe as a position squeeze that supported sterling.
Second, flows into the energy sector have provided tangible support for the pound. BofA’s Michael Hartnett notes energy stocks recorded their largest net inflow on record. The U.K. equity market ranks as the third largest among developed markets for concentration of energy-sector listings, and the sector’s strong relative showing versus the broader FTSE points to robust allocation flows into energy equities.
Although the U.K. remains a significant energy importer, its import dependence is lower than that of Japan, the Eurozone and Sweden, which in BofA’s view implies a more positive terms-of-trade shift for sterling versus EUR, JPY and SEK.
On the risk side, BofA’s analysis emphasises sterling’s consistent negative sensitivity to risk measures. The bank quantifies that a typical one standard deviation increase in VVIX - a measure of volatility in volatility - is associated with about a 5.43 basis point daily decline in the GBP trade-weighted index (TWI). For comparison, a one standard deviation move in FX volatility corresponds to roughly a 3.49 basis point daily decline, while bond volatility maps to about a 2.73 basis point daily decline. Because volatility has remained relatively subdued, positioning effects have been able to dominate sterling’s adjustments in recent weeks.
BofA cautions, however, that a sharp spike in volatility could reverse that dynamic. As a high beta, pro-cyclical currency, the pound could be vulnerable to outsized declines through more traditional risk-transmission channels should volatility surge.
Looking ahead, the bank draws attention to domestic political risk. With market attention currently focused on the Middle East, U.K. domestic issues have receded, but May local elections are less than two months away and BofA believes markets are underpricing the potential for a renewed rise in domestic political uncertainty. The bank notes that the two-month bucket of FX options now covers the election date, which increases the relevance of option-implied positioning in the run-up to the vote.
Given these factors, BofA has advised clients to hedge the recent bounce in sterling, with particular emphasis on hedging versus the euro in anticipation of a possible reversal ahead of May. The bank also characterises volatility as looking cheap at current levels.
While the pound’s recent performance has surprised some market participants, the bank’s analysis frames the move as a function of positioning and sectoral flows rather than a sign of fundamental improvement in the U.K. economy. The durability of the rally will likely hinge on whether positioning continues to dominate in the face of potential volatility spikes and the re-emergence of domestic political uncertainties ahead of upcoming elections.