A dramatic meeting is about to collide with the realities of British politics

LONDON – The British pound jumped to its highest level in two-and-a-half years following a hawkish rate hike from the Bank of England, but strategists warned that the UK’s upcoming budget could pose risks to investors and consumer sentiment.

Many investors await the Labor government’s new fiscal plan at the end of October before making long-term calls on the UK economy and property, as well as Prime Minister Keir Starmer’s warning decisions will be “painful” to society.

Labour, meanwhile, kicks off its annual party conference on Monday, the first in 15 years in power, as its leadership seeks to end a recent row over handouts and a promise to “rebuild Britain.”

The Band of England held rates as the Fed cut them last week. Both actions were expected, but the first struck a surprising tone as it emphasized the need for a gradual reduction, while the latter opted for a reduction of 50 points, as it emphasized the need to support the US labor market.

Sterling broke $1.33 against the greenback for the first time since March 2022 on Thursday, and was trading at $1.3315 in early London on Monday.

The pound’s rally was tied to the BOE’s communications and “looks perfectly justified,” said Chris Turner, head of global markets at ING, in a statement on Friday. Higher rates are traditionally beneficial for the domestic currency as higher yields can attract more foreign capital.

“The BOE seems to be questioning whether inflation will come down like elsewhere in the world… [the BOE] “I certainly don’t seem to be in the Fed’s ‘clear’ camp about inflation,” Turner said.

The main concerns of the central bank of the UK remain the rise in the price of services – which rose to 5.6% from 5.2% in August – and the growth of wages, which also holds more than 5% in the year.

Sterling’s gains last week built on a long-term trend, with analysts broadly identifying positives in the UK’s outlook since Labor’s landslide election victory in July due to factors including increased political stability, as well as plans to reform housing policy and strengthen ties with the European Union.

But the recent rise in the pound due to interest rate differentials could jeopardize the budget, due to be delivered on October 30, some warn.

The monetary policy “could be a test for GBP bulls if the tax hike ends the ongoing improvement in UK investor confidence,” Jane Foley, head of FX Strategy at Rabobank London, told CNBC by email.

Increases in value-added tax, national insurance – the general tax – and income tax have all been ruled out, but further tax increases, drastic reductions in public spending cuts may occur.

Labor has repeatedly stressed that boosting the UK’s sluggish economic growth is a priority.

UK retail sales growth of 1% in August helped support Friday’s positive outlook, “but leading indicators of consumer confidence are warning that consumers are starting to panic,” Turner said.

That could impact consumer spending and short-term growth.

Gabriella Dickens, G7 economist at AXA Investment Managers, also warned against the pound’s outlook in a note on Thursday.

A cut of 25 basis points in November would be accompanied by the Bank of England continuing to move “slowly” – and moreover, the main risk remains the budget, he said.

“This is likely to increase the pressure on the Bank to speed up the rate of reduction of funds if the monetary policy is tightened beyond what was set by the previous government,” said Dickens.

“This seems likely to us, given the latest signals from the new government, including talk of a £22 billion black hole in the public purse and hints of a possible tax hike. If the government tightens monetary policy too much, we think the Bank will be forced to increase the pace of the easing cycle to reduce the financial problems of households and businesses.”

ING strategists expect the BOE to gain more confidence in the UK’s inflation trajectory later in the year, which could see its rate drop accelerate after November’s rate cut in the markets.

“That may take time, however, and in the meantime, sterling can continue to do well,” Turner said, which could lead to a push towards the $1.35 area.

Although Bank of England Governor Andrew Bailey has denied that public sector wage increases are the main cause of inflation, policymakers will be wary of Labor’s “huge” spending spree, Huw van Steenis, Oliver Wyman’s vice chairman, told CNBC’s “Squawk Box Europe” on Friday.

Millions of public sector workers including teachers and doctors are set to receive massive pay rises under the UK’s new Labor government.

“One of the things that came from the UK banks was that they were hoping to hold costs next year, and they’re starting to panic and they’re going to have to settle,” he said.

He added: “If you read the [BOE] statement, it is clear that they are coming in, they want to be drawn slowly and written in bold.”