After recording its best quarterly gain in over 13 years, the GBP/USD closed the extremely volatile year slightly above 1.20. Monex Europe’s Simon Harvey said:
“Price action in the pound is reflective of thin market liquidity conditions, as is usually the case around this time of the year.”
The pound plummeted more than 27% since June 2021 to print a record low against the dollar in September this year. However, it reversed course in the final quarter to close the year losing "only" 10% against the US-backed currency, as investors increased their bets that the Fed will be forced to pivot from its ultra-aggressive tightening policy as inflation slows down.
Inflation Fueling Volatile Moves
The latest consumer price index (CPI) report in the U.S. showed that inflation has cooled down, raising hopes among traders that the Federal Reserve could slow the pace of interest rate hikes. This sentiment weighed on the greenback, sending it tumbling against a basket of currencies.
The U.S. central bank had a more aggressive approach to raising interest rates compared to other major economies in 2022, making dollar-denominated assets more appealing to investors. However, that trend could end soon and push investors away from the world’s reserve currency.
Despite its recent gains, GBP/USD remains over 10% in the red year-to-date (YTD). Looking to 2023, analysts are not very optimistic about the sterling’s outlook amid the expectations that the U.K. economy will struggle far more than other major economies in the future. Inflation in the U.K. remains substantially higher compared to the US., and one of the reasons for that is a depressing exchange rate, making imported goods in the U.K. more expensive.
Apart from the dollar’s retreat, the pound’s recovery in the latest quarter has been in part boosted by growing confidence that the U.K. is finally stabilizing its spending and borrowing plans after the mini-budget fiasco in September. Additionally, the sterling’s move higher was also driven by a drop in the price of foreign assets.
Until earlier this year, investors with overseas holdings have been reaping the rewards from a weaker sterling as it will have increased the value of their assets and sometimes even dividends in sterling terms. However, if the pound continues its upward trajectory, that boost will no longer be available.
Reputation Severely Damaged
The latest trend suggests that big investors may be reconsidering their support for the U.K. economy after months of political commotion and uncertainties around Brexit as analysts estimate a slow and bumpy recovery road.
While other economies and central banks are focused on taming inflation and stimulating economic growth, U.K. lawmakers are still working to restore fiscal and political credibility following the short but chaotic reign of Liz Truss.
The selection of the new Prime Minister, Rishi Sunak, provided some relief for the embattled U.K. markets, but global investors continue to dwell on the pension funds debacle and how the economy was standing on the brink of a financial collapse.
British funds saw the second-largest monthly outflows in history in November, suggesting that investors are far from confident in the U.K. economy. Further, sterling remains sharply down against the dollar and euro and is on track to record its worst year since the Brexit vote in 2016.
Just like its peers, Britain has also seen borrowing costs increase substantially this year. The government is looking to raise more than 300 billion pounds through bond sales in the financial year 2023/24. The planned bond sales from the BoE’s balance sheet are expected to put additional pressure on gilts by boosting supply levels.
Analysts are predicting that the U.K. is facing an extended recession, with official forecasts suggesting a 1.4% contraction in the country’s economy next year. This compares to 1.8% growth expectations in March 2022, before the Russia-Ukraine war escalated. Rating firm Moody’s expects U.K. government debt to remain above 100% of gross domestic product (GDP) for years to come.
Federated Hermes CEO Saker Nusseibeh said Truss’s chaotic leadership has significantly damaged the U.K.’s reputation overseas. On the other hand, he believes Truss deserved some credit for acknowledging that the U.K. economy needs a radical change to end its years-long period of sluggish growth.
Summary
After hitting record lows earlier this year, GBP/USD staged a strong rebound in the closing months of 2022, remaining one of the most popularly traded pairs on numerous forex trading platforms, as the pair posted the biggest quarterly gain in over 13 years. Still, some analysts are cautious that the U.K.’s economy may underperform in 2023, which could again weigh on the pound’s performance.