Feel-good factor for sterling fading already?

A 'Brexit' is a very big risk: Kaletsky
A 'Brexit' is a very big risk: Kaletsky   

Jitters about austerity and a potential exit from the European Union (EU) mean a feel-good factor that lifted Britain's currency after a general election less than two weeks ago has quickly faded.

The election on May 7 delivered the first outright majority for the ruling Conservative Party in 23 years, bringing stability and certainty where analysts had predicted a hung parliament with no one party winning an overall majority of seats.

This unexpected outcome helped sterling to put in its best performance in six years against the dollar in the past two weeks, according to data from Thomson Reuters.

"The feel-good factor has been helping sterling but it's fair to say that the reality for sterling in the next few months will be dominated by two topics," Rabobank Senior Currency Strategist Jane Foley told CNBC on Monday.

"These are the EU referendum and the likelihood that fiscal austerity could become more of a tangible headwind to growth in the months ahead," she added.


U.K. Prime Minister David Cameron
Getty Images
U.K. Prime Minister David Cameron

The pound was trading at about $1.5671 on Monday, more than a cent below a 5-1/2 month high hit last week at $1.5815.

"It's rallied a long way after the election and it's very expensive. You've got a level in the currency that makes it difficult to buy," Kit Juckes, macro strategist at Societe Generale, told CNBC on Monday.

Brexit woes

A referendum on U.K. membership of the EU, which Prime Minister David Cameron has promised to hold by the end of 2017, is one headwind sterling now faces, analysts said.

Read MoreWhy UK's EU referendum may be sooner than you think

The risk of the U.K., one of Europe's biggest economies, leaving the EU is not overdone, Anatole Kaletsky, co-chairman and chief economist at Gavekal Dragonomics, told CNBC Monday.

"Brexit and the debate about Brexit before a vote is a big risk and is going to be the dominant factor for British financial markets over the next year to come," he said, using the term "Brexit" that analysts often use to describe Britain's potential withdrawal from the EU.

"Brexit is a big risk because we are more dependent on capital inflows than any other major economy in the world," he added.

In short, said analysts, uncertainty about the referendum outcome could encourage businesses and investors to delay investment decisions, hurting the economy and sentiment towards the currency.

What, more austerity?

Adding to the cloudier outlook for sterling was news on Friday that U.K. Chancellor of the Exchequer (or Finance Minister) George Osborne would present a new budget to parliament on July 8 to outline how the government would cut £12 billion ($18.8 billion) from the country's welfare bill.

Read MoreHas Krugman been proved wrong on austerity

Analysts said there was a risk that a new emboldened government could present further austerity measures to bring the budget deficit down – a move that could weigh on economic growth, push out the timing of potential interest-rate rises by the Bank of England and undermine the pound.

The Conservative government plans to turn the U.K. budget deficit, forecast at £75 billion this year, into a surplus by 2020.

"The risk that austerity is bought forward is clearly negative for growth, that could weigh on the markets' perception of when the Bank of England can hike interest rates and consequently effect sterling," said Rabobank's Foley.

She said the pound was likely to trade closer to a range of $1.50-$1.52 for the rest of the year, compared with current levels.