Pound's Uneven Recovery Hides Worst Year Since Brexit Referendum

The pound has had a turbulent year, and there is little evidence that 2023 will be much different.

There are increasing signs that the UK economy is heading for a downturn, which has analysts questioning whether the recent rebound in the value of the pound against the dollar can be maintained. Traders in the options market also remain pessimistic about the long-term outlook.

The pound has surged from an all-time low reached in September, boosted by a change of government following Liz Truss’ ill-fated tenure as leader and a weakening dollar. However, it is still down 11% in 2022, headed for its worst year since the Brexit vote in 2016.

Looking ahead to next year, it is possible that central bank policy divergence will limit gains, with the Bank of England appearing increasingly dovish compared to other central banks. Additionally, the UK economy is struggling, the budget deficit has increased dramatically, and double-digit inflation has led to the sharpest drop in living standards on record. This has curbed spending and given rise to the worst industrial unrest in decades. Additionally, the housing market looks vulnerable to a sharp correction.

John Hardy, head of FX strategy at Saxo Bank, has warned that the UK economy is at risk of slipping into recession. He cites the combination of a slow-moving BOE on interest rates and the austere fiscal picture as key factors that could weigh down on the pound.

Here are four charts that provide additional insights into the pound's movements in 2023:

The pound erased losses triggered by Truss' efforts for vast funded tax cuts within two weeks, but it took more than two months for one-year risk reversals to return to pre-budget levels. The slow recovery of this widely followed barometer of market sentiment suggests that traders remain strongly downbeat on the pound over the long run, and that the rebound in the spot market was more based on positioning than an outright bullish expression.

Leveraged funds switched to being net short on the pound in the week to Dec. 13, after previously being long, while asset managers retained a short position, according to the latest data from the Commodity Futures Trading Commission.

There are mixed signals for the pound from a technical standpoint. The most notable is a bearish moving averages crossover on the monthly chart, which comes at a time when Bloomberg's fear-greed indicator shows that bears are still in control of price action despite the rebound seen in the fourth quarter. This suggests that downside risks prevail for the pound over the medium term.

JPMorgan Chase & Co. analysts believe that the sterling will fall to $1.14 by the end of the first quarter. They cite the UK's negative growth outlook as the primary reason for their prediction. Local elections in May could also add to the political uncertainty in the UK, furthering the decline of the sterling.

According to a survey of strategists by Bloomberg, the pair is expected to drop to $1.17 in the first quarter before staging a mild recovery to $1.21 by the end of 2023.

Yield spreads between two- and 10-year swaps tied to the overnight rate suggest that the UK economy may face a longer downturn than its main peers. The difference between one-year forward and current spreads suggests that yield curves in Europe and the US will steepen more than in the UK, indicating that the UK may experience more economic hardship in the near future.

Investors are betting that the ECB's terminal rate will be higher than the BOE's, following this month's policy decisions.

The pound may weaken against other major currencies in the near future. Some analysts believe that the euro could strengthen to 0.90 pence as soon as June, compared to its current value of 0.88 pence. This would be due to the European Central Bank's more hawkish stance on interest rates, in contrast to the Bank of England's more dovish stance.

The sterling may weaken against the yen as the Bank of Japan is seen edging closer to tighter policy. According to Kit Juckes, chief FX strategist at Societe Generale SA, the pair may be heading back toward 120, a level it hasn't touched in more than a decade.