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A material shift in Bank of England rate expectations owing to the war shifts pound sterling's outlook against the euro says one of the world's top-tier investment banks.
Royal Bank of Canada (RBC) has upgraded its pound-euro forecast profile, noting that the pound can benefit as volatility falls and UK interest rates reset at higher levels for longer.
"The Iran conflict has materially altered the near-term outlook for sterling. The BoE held its policy rate steady at its March meeting," says RBC's Capital Markets division in a monthly FX forecast update.
"The MPC will remain wary of inflation expectations, already elevated from recent shocks," it adds.
The pound fell against the euro ahead of the Iran war as markets priced between two and three Bank of England interest rate cuts for 2026. That weighed on short-term UK bond yields and the pound.
(That's because international capital chases higher interest rates as investors seek positive returns).
But, the conflict in the Middle East radically altered interest rate expectations; at one point in March the market shifted to expecting as many as two rate hikes in the year. That's a round journey of 100 basis points for Bank Rate expectations in a 'hawkish' direction.
Inevitably that helped the pound, which rose to €1.16 by the middle of the month, with analysts confirming central bank policy divergence was behind the move.
"GBP has performed solidly versus its G10 peers since the conflict broke out. That is somewhat surprising since the UK is a significant net oil importer and has been one of the higher yielding G10 currencies," says RBC.
RBC explains that it's usually the case that higher-yielding currencies suffer in volatile environments.
"However, recently we have seen a sharp fall in GBP volatility, which has made those carry trades attractive once again," says RBC.
UK bonds tend to have a higher yield than Eurozone peers owing to a combination of relatively higher expectations for inflation and the Bank of England's response. The conflict reinforces that.
What's more, RBC noted in March's currency forecast update that "the euro becomes a funding currency during energy shocks."
The movement of money from lower yielders to higher yielders (i.e. EUR to GBP in this instance) is referred to as a carry trade.
Because of these developments, RBC raised its forecast profile for the pound-euro exchange rate (lowered its EUR/GBP profile).
It sees EUR/GBP ending the year at 0.86 from a prior forecast of 0.88, (that's a GBP/EUR forecast of 1.1613 from 1.1363). End-2027 is unchanged at 0.89 (GBP/EUR at 1.12).