Rabobank expects the pound to lose most of its 2026 gains versus the euro, citing political uncertainty, fiscal challenges, and shifting interest rate expectations as key risks for the UK currency in the coming quarters
The pound sterling's recent period of relative calm may be giving way to a more persistent decline against the euro, according to new analysis from Rabobank. The bank's latest forecasts suggest that the pound-to-euro exchange rate, which peaked at 1.1820 in July, is now set for a multi-quarter downtrend that could erase much of the currency's earlier 2026 advance. This outlook comes as the pound has become one of the weakest performers among major currencies over the past month, trailing only the Swiss franc and the US dollar.
Rabobank attributes the pound's vulnerability to a combination of political and economic factors. The transition to Prime Minister Burnham's government has brought a series of policy pledges, including promises of growth in every postcode and the removal of VAT on household electricity bills. However, these commitments are paired with a pledge to maintain fiscal rules and avoid tax increases for workers, raising questions about how the government will fund its agenda. Reports indicate that the government may seek to reclassify certain spending as 'assets' to create additional fiscal space, but this approach could increase the supply of government bonds and put further pressure on the pound if investors remain unconvinced about the sustainability of public finances.
Fiscal Policy and Market Sensitivity
The upcoming autumn budget, scheduled for October 28 and to be delivered by Chancellor Healey, is expected to be a key test for the government's fiscal strategy. With Parliament in recess until September, political news is likely to be limited, but any early details about the budget could influence both bond and currency markets. The bond market has already shown sensitivity to fiscal signals, with a notable sell-off in both gilts and sterling following initial suggestions of greater flexibility in fiscal rules after Burnham took office.
Interest rate expectations are also playing a central role in the pound's outlook. While some market participants still anticipate at least two Bank of England rate hikes by 2027, Rabobank argues that these expectations may be too optimistic. Recent progress toward reopening the Strait of Hormuz has eased energy-related inflation concerns, reducing the perceived need for further tightening. Although three members of the Bank of England's Monetary Policy Committee voted for a rate increase in July, Rabobank believes the threshold for additional hikes remains high, especially as Governor Bailey has highlighted factors such as slowing services inflation, weaker household demand, and a more flexible labour market as reasons to keep rates steady for the rest of the year.
Yield Spreads and Exchange Rate Forecasts
As UK rate hike expectations have faded, the yield spread between UK and German two-year government bonds-a key driver of sterling's earlier strength-has narrowed to its lowest level since 2026. Meanwhile, expectations for further rate increases by the European Central Bank and the US Federal Reserve have kept the euro and dollar relatively supported. According to Rabobank, a pound stripped of its yield advantage and facing renewed fiscal risk is likely to remain under pressure.
For those watching the pound-to-euro exchange rate, Rabobank's strategy favours buying euros on dips, particularly if the EUR/GBP rate approaches the 0.8550 area. A move above 0.8588 could signal further upside for the euro. In practical terms, this means selling sterling rallies toward 1.1696, with a drop below 1.1644 indicating that the downtrend is accelerating. Rabobank's forecasts put the pound-to-euro rate at 1.16 in three months, 1.14 in six months, and 1.13 by mid-2027, implying that the pound could give back all of its 2026 gains.
Not all analysts share Rabobank's bearish view. Lloyds Bank, for example, projects the pound-to-euro rate above 1.20, arguing that yield differentials will remain more influential than political developments and could help stabilise the currency. The October 28 budget is shaping up to be a decisive event that may determine which scenario prevails.
Recent Performance and Data
In July 2026, the pound-to-euro exchange rate reached a high of 1.1820 before beginning its current decline. Over the past month, the pound has ranked as the third weakest G10 currency, with only the Swiss franc and US dollar performing worse. The UK-German two-year yield spread, which had supported sterling earlier in the year, has now compressed to its lowest point of 2026, reflecting shifting expectations for monetary policy on both sides of the Channel. For further context on how narrowing yield spreads have affected the pound's performance against both the euro and the dollar, see this analysis: how yield spreads have recently weighed on sterling.
Understanding the interaction between fiscal policy, interest rates, and exchange rates is essential for interpreting the pound's current trajectory. Fiscal rules are designed to limit government borrowing and maintain investor confidence, but creative accounting or reclassification of spending can test market patience. When investors perceive that fiscal discipline is weakening, they may demand higher yields on government bonds, which can in turn put downward pressure on the currency. At the same time, the relative attractiveness of a currency is shaped by expectations for central bank policy and the yield available compared to other major economies. In periods of uncertainty, even small shifts in policy or market sentiment can have outsized effects on exchange rates.
