The pound’s outlook for 2026 has been upended by a surge in global energy prices, as the escalating conflict in the Middle East forces markets to reassess inflation and interest rate expectations.
What was previously expected to be a year of Bank of England (BoE) rate cuts has quickly shifted, with investors now weighing the prospect of higher borrowing costs and a more volatile path for Sterling.
With GBP/USD having struck a four-year high in late January, the pairing then slumped to a three-month low in March as the US-Israel war with Iran saw the safe-haven US dollar soar.
Meanwhile, GBP/EUR hit a seven-month high in March. USD strength and fears of a European energy crisis weighed on the euro, while BoE rate hike bets supported Sterling.
Looking ahead at the remainder of 2026, the outlook remains murky and deeply contingent on how the Middle East crisis unfolds.
In the near term, we expect the pound to remain volatile amid the current geopolitical uncertainty, with shifting interest rate expectations and bond market movements potentially creating turbulence for GBP.
The length and intensity of the Middle East crisis could also determine the pound’s performance in the long run. A swift end to the conflict could be beneficial to GBP, while a protracted war and global energy shock raise UK stagflation risks.
GBP/USD could potentially strengthen overall if geopolitical tensions ease and the Federal Reserve resumes cutting interest rates. Meanwhile, GBP/EUR could remain resilient if the BoE decides to hold or hike interest rates this year.
That said, domestic political news could generate headwinds for the pound, with Prime Minister Keir Starmer staring down a leadership challenge after the May local elections.
GBP forecast for 2026: Middle East inflation shock could determine the pound’s direction
The eruption of violence in the Middle East has triggered unpredictable movement in the pound this year, with analysts trying to assess the impact on UK inflation and economic growth.
A key driver of GBP will be BoE policy. Prior to the war, markets had priced in multiple rate cuts this year. Now, market participants expect the bank to raise interest rates as the jump in oil prices drives up inflation, with the UK particularly sensitive as it is a net importer of energy.
While the prospect of higher interest rates could lend Sterling support, the inflation shock also carries risks. A prolonged energy crisis could hit the UK economy hard, leading to weak growth, high inflation, and restrictive interest rates – a toxic combination.
Another notable factor in the 2026 outlook for GBP is the British political landscape. Prime Minister Keir Starmer staved off a leadership challenge when Chancellor Rachel Reeves delivered her bond-friendly budget in November, but the real test comes with the May local elections.
If Labour performs as poorly as expected in May, disgruntled MPs could attempt a coup. While Starmer is likely to survive an attempt to oust him, such a bout of political instability could be enough to pressure the pound, reminding markets of the chaotic final years of the Conservative government.
Additionally, signs of a dysfunctional government could introduce fresh risk premiums into the pound and UK bond markets. A rise in gilt yields could eat away at Reeves’s hard-earned headroom, a problem that could spiral into further fiscal tightening and more political discontent.
The crisis in the Middle East could create further headaches for Reeves. Rising inflation and higher interest rate expectations may drive up the cost of servicing government debt, just as the Treasury increases spending to support households with higher energy bills.
As a result, Sterling faces significant uncertainty in the near term. The best outcome for the pound would likely be a swift resolution to the Iran war, with a temporary inflation shock prompting the BoE to take a more hawkish approach without severe damage to the UK economy. However, the outlook remains fragile, and the path ahead is highly uncertain.
A possible tailwind for GBP could come from UK-EU trade relations, as the government pushes ahead with its planned ‘reset’ of ties with Brussels. Such a shift in post-Brexit policy could be supportive for Sterling, as reduced trade frictions would likely improve the UK’s growth prospects.
Will the pound get stronger against the euro?
The GBP/EUR outlook for 2026 was already deeply uncertain before war broke out in the Middle East, and it remains highly contingent. That said, the forecast for the pound euro exchange rate has improved, with the surge in energy prices potentially removing a key headwind for GBP against EUR.
Markets had expected the BoE to continue cutting interest rates in 2026, while the European Central Bank (ECB) was expected to hold steady. This policy divergence could have led to GBP losses against EUR.
However, bets have now shifted. Both central banks are expected to hold or even hike interest rates this year, with the BoE anticipated to be slightly more hawkish than the ECB, due to higher UK inflation. This could see the pound get stronger against the euro in 2026.
Meanwhile, growing geopolitical anxiety presents another downside risk to the euro. While the Middle East has dominated headlines recently, the Russia-Ukraine war continues, and surging oil prices have helped refill the Kremlin’s war chest.
There is a potential positive for the single currency in the months ahead, stemming from the euro’s strong negative correlation with the US dollar. If the Iran war ends, a drop in USD could revive EUR demand.
Likewise, if the Federal Reserve cuts interest rates later in the year, EUR could benefit from a weaker US dollar.
Will the pound get stronger against the US dollar?
Whether the pound will get stronger against the US dollar depends heavily on the situation in the Middle East, particularly how it impacts market risk appetite and monetary policy. We believe the odds are tipped slightly in GBP’s favour, although there is also a chance that USD comes out on top.
The key factor for our GBP/USD forecast is central bank policy. While the BoE is expected to hold or hike rates in 2026, markets still anticipate at least one cut from the Fed by year-end.
This is because the US, as a net exporter of oil, is more insulated (although not fully protected) from the inflationary shock of surging energy prices.
Meanwhile, market risk appetite remains an important factor for the dollar. Many were hopeful that 2026 would bring peace in Ukraine and cooling tensions internationally. Instead, we’ve had the US invasion of Venezuela at the very start of the year, along with Donald Trump’s threats to Colombia, Cuba, and Greenland, and the spiralling crisis in the Middle East.
If the US, Israel and Iran can negotiate an end to the war, a recovery in risk appetite could weigh on the dollar. Conversely, if the conflict continues to escalate then USD could strengthen.
Beyond the Middle East, geopolitical tensions in Ukraine, Taiwan and South America all present risks. Any further conflicts – whether military or economic – could weigh on risk sentiment and favour the safe-haven dollar over the increasingly risk-sensitive pound.
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