For much of 2022, the GBP faced a myriad of political and economic challenges as it navigated a steady churn of political and economic turmoil that dented investor confidence in the currency.
These challenges were further compounded by macroeconomic headwinds. With the wider global economy grappling with a war in Europe, surging inflation, and an energy crisis, any form of growth was hard to come by for the GBP.
The situation worsened during September’s mini budget. As the markets were spooked by Liz Truss’s unfunded tax cuts, the GBP experienced a sharp decline to record lows ($1.0856) against the USD, marking its worst month in nearly four decades. As a result, the GBP finished the year as one of the weakest-performing currencies among the G10 nations.
However, a small ray of hope appeared with the arrival of Rishi Sunak and Jeremy Hunt, who were brought in to rebuild the economy and stabilise Westminster. This sense of stability enabled the GBP to gradually recover. It currently stands at $1.28 against the USD, making it one of the strongest-performing currencies since December 2022.
Despite this progress, the outlook for the GBP remains uncertain. Persistent core inflation has defied earlier projections, and there are indications of faltering economic growth, resulting in a recent shift in market expectations for the currency.
Changing expectations for the GBP
At the beginning of this year, analysts and economists generally agreed that the Bank of England’s interest rate hiking cycle, which had dominated much of the discourse around the GBP in 2022, would act as a cooling force on the economy.
Therefore, with the UK steering clear of a recession in the final quarter of 2022, market forecasts suggest that the Bank of England’s monetary tightening measures were nearing an end, especially because the economy experienced surprisingly robust growth in January. Bolstered by this positive sentiment, the markets adjusted their growth projections for the UK, aligning them with those of other major economies, thus enhancing the outlook for the GBP throughout the remainder of 2023.
However, contrary to projections, inflation failed to subside as anticipated. With core inflation remaining stubborn at 6.9%, it is now evident that further rate hikes are required. As a result, market pricing in interest rate markets now point towards further – if less drastic – hikes, with the base rate expected to peak at 5.75% by the end of 2023.
What’s in store for the GBP?
According to conventional wisdom surrounding currency performance and interest rate expectations, when a central bank appears inclined to further raise its base rate, the local currency typically enjoys upward momentum due to increased foreign investment demand. Given the expectations of the Bank of England’s intention to hike its base rate in response to escalating core inflation, one could reasonably anticipate a positive outlook for the GBP. Mutch of these expectations have all been fully priced in now as higher rates have been expected for some time.
Emerging signs in recent weeks indicate that the UK economy might be heading towards a period of stagflation – or, perhaps even more concerning, a potential recession which means the GBP looks like to remain pressured in the near to medium term. The primary reason behind this is that the markets believe the Bank of England will need to continue raising the base rate before inflation falls to more acceptable levels. However, such a consistent and rapid series of rate hikes could prove highly destructive to the purse strings of many UK businesses and consumers, especially those with mortgages.
Certainly, with the cost of borrowing rising further, businesses will face higher expenses for investments, expansions, and essential operational activities, while homeowners will see their spending power being reduced even further. With less money circulating around the economy, further rate hikes will be extremely prohibitive for UK economic growth.
For investors, therefore, the GBP’s risk factor is that any gains that currency has made this year will quickly be lost to a mass sell-off on fears that the UK will enter a stagflationary or recessionary period. If the BoE indicates that the base rate will rise as high as the markets are already expecting, such a situation would be increasingly likely.
Investors should look to the bond markets
In terms of tracking the currency in the months ahead, investors should look to bonds; indeed, early signs of economic turmoil frequently first emerge in the debt securities markets.
As an illustration, during the announcement of Liz Truss’s disastrous mini-budget in September 2022, the UK gilt markets experienced a dramatic crash, losing a staggering £1.2 trillion (28%) in value. This plunge in the gilt markets drove bond yields to nearly 4.5%, reaching their highest point since the middle of the previous financial crash in October 2008, and underscoring the reliability of the bond markets as an indicator of the economy’s future direction.
This is important; in the past few weeks, the gilt markets have experienced comparable price declines, and ten-year yields have surpassed the levels seen in October 2022. This surge in yields suggests that the markets anticipate more turbulence on the horizon for the UK economy. As recessionary and stagflation fears intensify, it is likely that investors will begin to sell off the GBP, leading to a decline in the currency’s price.
In summary, the future of the GBP remains uncertain due to the ongoing economic climate. The combination of rising inflation and the possibility of additional interest rate hikes has created a complex environment for investors to navigate. Therefore, keeping a close eye on bond markets and diligently monitoring economic indicators will be of utmost importance in navigating the dynamic landscape surrounding the GBP in the months ahead.
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