Since the beginning of this year, the pound has been one of the best performing currencies. After entering July, the rise of the pound accelerated. XTB's research director Kathleen Brooks stated that three factors are driving the strength of the pound, which may continue to exert upward pressure on the pound in the medium term.

1. Interest rate difference

The interest rate spread is a key fundamental driving factor for currencies, currently favorable for the pound.

The real interest rate in the UK is 3.25%, while in the US it is 2.5%. At present, the rise in real interest rates between the UK and the US is driving the strength of the pound against the US dollar, and it may only continue to grow.

At present, the probability of the Federal Reserve cutting interest rates in September is 90%, and the market currently expects the Fed to cut interest rates more than twice this year. In contrast, the likelihood of the Bank of England cutting interest rates in August is 57%, and the market expects the UK to cut interest rates less than twice this year.

2. Economic growth and inflation forecast

In recent weeks, the growth prospects in the UK have improved. After a flat GDP growth in April, the GDP growth rate in May was 0.4%, contrary to the expected growth of 0.2%.

The growth in output from the construction industry and the slight increase in the service industry index have driven GDP growth, with the service industry index increasing by 1.1% on a three-month basis. Therefore, we may see the Bank of England raise its economic growth forecast at its next meeting in August. This also reduces the possibility of the Bank of England cutting interest rates, as it is unusual for the Bank of England to cut interest rates while raising its recent GDP expectations.

The inflation forecast for the UK may also be raised. The expected CPI for this year is 2%, and for next year it will be 2.6%. However, the increase in living wages in April may still pass through core inflation later this year, and the new Labour government may want to further extend living wages. However, this plan may not be discovered until later this autumn's budget.

The Bank of England has ample reason to wait until the new government's first budget is released before cutting interest rates, which may also be beneficial for the pound, especially considering that high interest rates do not seem to hinder the UK's sustained recovery from last year's recession.

3. Political risk premium

As the Labour government formulates growth friendly policies and establishes closer ties with the EU, the political risk premium that has limited the rise of the pound in recent years may decrease.

This will not boost the pound in the short term, and its impact on the pound is difficult to measure.

However, now that the UK appears politically stable, especially compared to France and the US, the pound may attract "safe haven" funds in the coming months.

Brooks said that if the pound to dollar exchange rate can break through 1.30 in the next few days, it may rise by a level of 1.40, which is the highest level since 2021.

Daily chart of GBP/USD