Above: Prime Minister Rishi Sunak and Chancellor Jeremy Hunt. Image: Gov.uk.

"Better, but not good," is how Goldman Sachs analyst Michael Cahill describes the British Pound's prospects in the wake of Rishi Sunak's anointment as Prime Minister.

Cahill and his colleagues have lifted their point forecasts for Sterling following recent political and economic developments in the UK, however the revised targets suggest the currency is by no means ready to rally.

"After serving as the centre of the financial market storm for a few weeks, with fiscal and monetary policy out of step with each other and the macro backdrop, now they appear to be moving in a more cohesive and coherent direction," says Cahill, in a weekly currency market research briefing.

Sunak and his Chancellor Jeremy Hunt will preside over a regime of higher taxes and lower spending as they try to convince the market they can be trusted to deliver sound fiscal policy.

"The more cautious policy approach was on clear display ... in reports about the upcoming budget release. Estimates have suggested that the government likely needs to fill a budget hole of around GBP 35bn," says Cahill.

The policy stance marks a sharp contrast to the swingeing tax cuts and stimulatory policies of Liz Truss and Kwasi Kwarteng, which were judged to be the wrong prescription for an economy suffering surging inflation levels.

The loose fiscal policy of Sunak's predecessor jarred with the Bank of England's own programme of higher raising interest rates in order to combat inflation, ensuring UK fiscal and monetary policy were pulling in opposing directions.

The Truss and Kwarteng 'mini budget' triggered a plunge in the value of the Pound and surging UK gilts as investors baulked at unfunded tax cuts which posed questions on the sustainability of the UK's finances.

The market's relief over Sunak and Hunt's policy reset was expressed via a higher Pound and falling gilt yields.

"Markets have responded to this change in strategy by taking down the risk premium on UK assets significantly. We think this is appropriate," says Cahill.

Goldman Sachs has raised its forecasts for the Pound accordingly but notes that these revised levels remain lower than where spot currently is, suggesting the recent rebound has overextended.

"It should be emphasised that the UK economy remains in a difficult position, and this mostly takes policy back to where they were a few months ago when Sterling was still the main adjustment mechanism for negative external shocks—ranging from energy supply to ongoing Brexit frictions," says Cahill.

He adds that from current levels, risks still appear to be skewed to the downside given how much is priced into the Bank of England.

Money markets show investors expect more interest rate hikes (+142 basis points) from the Bank of England than any other developed central bank, suggesting a significant squeeze in UK economic activity lies ahead as consumers and businesses adjust to the higher cost of finance.

"Taking these things together, we are revising our Sterling forecasts in a more positive direction, but still expect some further GBP underperformance ahead," says Cahill.

Goldman Sachs now forecasts EUR/GBP to trade at 0.88, 0.87, and 0.86 in three, six, and 12 months, down from 0.92, 0.90, and 0.88 previously.

In Pound to Euro terms, this equates to 1.14, 1.15 and 1.17, up from 1.09, 1.11 and 1.14.

This implies a Pound to Dollar forecast profile of 1.10, 1.11, and 1.22 (vs 1.05, 1.08, and 1.19 previously).

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