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United Kingdom


The Bank of England’s fight against incredibly-sticky inflation has seen terminal rate expectations climb to 6.5 percent and above in recent weeks, helping tilt rate differentials firmly in the pound’s favour. But hard landing vulnerabilities are growing, suggesting that risks to the exchange rate are increasingly weighted on the downside.

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The British pound is performing remarkably well, with a substantial shift up in interest rate expectations following a string of better-than-predicted data prints, re-accelerating core inflation, and aggressive Bank of England policy tightening underpinning its move upward. It is holding near ten-month highs against the euro and fourteen-month highs against the dollar, and is the strongest in eight years relative to the yen. But – in contrast to our thoughts around some other currencies such as the Japanese yen and Chinese yuan – we believe there is now a lot of good news factored into the exchange rate. Incoming events and data could be hard pressed to exceed current lofty expectations.

Cumulative change in interest rates since October 2021, %

Short term gain could bring long term pain.

For the pound, the path forward is heavily contingent on the performance of the UK economy, and to a lesser extent how the Eurozone economy is travelling. Hence, from our perspective, a more positive outlook would require the economy to continue delivering positive surprises relative to market consensus. This may result from ongoing resilience in household consumption, or an upswing in business investment. Ongoing strength, combined with stubbornly high inflation could see the Bank of England press on with additional aggressive interest rate hikes. While positive in the short term for the exchange rate, over the longer run, this could result in a sharper economic downturn and larger pull-back down the track.

Balance of payment risks remain substantial.

A somewhat more bearish outcome for pound would likely come from a more protracted and pronounced period of UK and global economic weakness, especially if it occurs with inflation still well above target. A “stagflation” scenario – in which growth stays weak, and inflation remains uncomfortably high – could accentuate the country’s yawning current account deficit (~3.7 percent of gross domestic product). A further deterioration in an already-precarious balance of payments position could see the pound adjust lower to attract the capital needed to fund the external imbalance.

GBPUSD versus UK terms of trade

While the UK’s higher interest rate structure might help the pound hold up against the US dollar, we see it underperforming other currencies such as the euro and Japanese yen over the third and fourth quarters – and progressively losing ground against the Australian dollar as 2023 rolls on. This reflects our comparatively-bearish take on the country’s economic prospects, exacerbated by a persistently large current account deficit and weaker terms of trade.
The British economy has so far held up better than anticipated. But with interest rates moving deeper into restrictive territory, and real wages remaining negative, we believe a sharp slowing in activity in the outsized household consumption sector is on the horizon. At the same time, investment trends remain sluggish, with the aftereffects of Brexit constraining potential growth. This combination points to rising odds on a rather meaningful deterioration in the labour market over the period ahead. If realised, this could see markets pare back remarkably bullish terminal rate projections, taking some of the heat out of the pound