Can sterling hold gains as war risks hit UK economy?

The British pound took a breather on Wednesday after its longest winning streak in a year, slipping against the US dollar as improving sentiment around a possible resolution to the Iran war weighed on the safe-haven greenback.The dollar had fallen to six-week lows as investor optimism picked up, prompting some cooling in sterling’s recent gains.Sterling was last steady at $1.357, after rising nearly 3% since hitting four-month lows at the end of March. The currency had advanced for seven consecutive sessions, marking its longest streak since a 10-day run last April.IMF cuts UK growth outlook sharplyDespite the recent rally, analysts warned that sterling’s strength may not last long due to mounting economic risks.The International Monetary Fund has downgraded Britain’s economic growth forecast for 2026 to 0.8%, down from a previous estimate of 1.3%. This marks the sharpest downgrade among major advanced economies and the largest revision for any Group of Seven nation.The downgrade reflects growing concerns over the economic fallout from the Iran war, which has disrupted global energy markets and weighed on growth prospects.Energy prices push borrowing costs higherThe UK’s reliance on imported natural gas has intensified pressure on the economy. Gas prices have surged roughly 40% since the conflict began, adding to inflationary pressures.Rising energy costs have also driven up government borrowing costs. Two-year UK bond yields have climbed nearly 70 basis points since late February, reaching around 4.2%, making them the worst-performing among major economies.This sharp rise in yields has led traders to price in the possibility of interest rate hikes by the Bank of England later this year.Rate expectations shift as sentiment improvesHowever, improving sentiment around a potential easing of disruptions to oil flows through the Strait of Hormuz has led to some moderation in those expectations.Analysts noted that as market optimism grows, the urgency for aggressive rate hikes may diminish, putting downward pressure on the pound.As quoted in a Reuters report, ING strategist Francesco Pesole said, "All in all, the latest developments keep us confident with our call that front-end rates have further to fall in the UK than the euro zone and that should offer lasting support to euro/sterling beyond the near-term."He added, "...The pair is suffering a bit from improved risk sentiment, but rate differentials will return as primary drivers once the dust has settled."Euro-sterling dynamics remain in focusThe euro remained under pressure against the pound despite recent developments.The euro is still down nearly 1% against sterling since the start of the conflict and was last flat at 86.94 pence.This suggests that while sterling has paused, broader currency dynamics remain influenced by relative economic outlooks and rate expectations.BoE highlights inflation risksMeanwhile, Bank of England policymaker Megan Greene emphasised the uncertainty surrounding inflation and growth.Speaking on Tuesday, she said, it could take months to fully assess the long-term impact of the energy price shock on the UK economy.Greene added that upside risks to inflation remain a key concern, signalling that policymakers may need to act pre-emptively despite limited data clarity.Overall, the pound’s recent rally appears fragile as geopolitical developments and economic uncertainties continue to shape market expectations.