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What to expect from the pound in 2023

Pound and US dollar banknotes in illustration
A more valuable pound means importing goods, such as food and petrol, becomes less expensive for businesses and consumers. Photo: Dado Ruvic/Reuters

The pound (GBPUSD=X) had a rollercoaster ride against the dollar in 2022, with this year set to be its worst annual performance since the Brexit referendum in 2016.

In mid-January sterling hit its peak for the year, as £1 bought $1.37, however, in the chaos of Kwasi Kwarteng’s mini-budget in September it slumped to its lowest level ever, touching $1.0350 for the first time.

Although it quickly recovered from its record lows, trading back above $1.2000, it will need to hold above this level to gain investor confidence going into the new year.

Read more: 2022: Year in review

“A move to 1985 levels on the GBP/USD rate was not on anyone’s prediction list, but then neither was the ability of the UK political class to spontaneously self-combust in spectacular fashion, which brings us to where we are now,” Michael Hewson of CMC Markets said.

October saw the first real positive month for cable, with November also seeing good gains. A more valuable pound means importing goods, such as food and petrol, becomes less expensive for businesses and consumers.

Another notable factor this year has been the swing in UK two-year gilt yields which surged from 0.687% at the end of last year, peaking at 4.72% in September and falling to sit just above 3%.

In contrast, the dollar had a strong year against a basket of currencies as traders once again piled into the safe-haven. It touched levels not seen since 2002, and is on track to close at its highest levels in 20 years.

However, in recent weeks the US greenback has started to fall back against the pound as US inflation cools, and the Federal Reserve shifts away from aggressive rate hikes.

Official figures showed that US inflation rose just 0.1% in November, lower than economists had expected and the smallest increase in almost a year.

Analysts have suggested that the dollar has now reached its peak, which was also seen from the way it reacted against the Japanese yen in December.

Read more: UK economy shrinks by higher-than-expected 0.3% as recession looms

In addition to this, the pound’s performance against the likes of the euro (GBPEUR=X), the Japanese yen (GBPJPY=X), and the Swiss franc (GBPCHF=X) has not been anywhere near as poor as it has against the dollar.

Hewson added: “Just looking at the performance of the pound through the lens of the US dollar can offer a distorted picture, although even against the rest of its peers the pound’s performance hasn’t been great.”

The pound ended 2021 at $1.3530 with traders optimistic after the Bank of England (BoE) was the first major central bank to hike interest rates since the onslaught of COVID.

It increased rates in December of that year by 25bps to combat rising inflation, which had jumped to 5.1%.

Fast forward to today and UK inflation is now 10.7%, more than five times higher than the Bank’s 2% target. Threadneedle Street has since hiked rates at nine consecutive meetings, pushing interest rates to 3.5%.

Watch: How does inflation affect interest rates?

Sterling is likely to be affected by continual BoE rate rises, which are expected to climb as high as 4.5%. How long rates stay at, or above, current levels will also come into play.

If a move through the 1.2000 level can be sustained, then a move back towards 1.3000 is likely to be achievable in 2023, especially if the US dollar undergoes a big reversal.

However, there have been warnings that there are likely to be surprises along the way after global equities fell into a bear market, and recession is looming.

The BoE said it now expects UK GDP to decline by 0.1% in the final quarter of 2022, which is 0.2 percentage points stronger than expected but would still show the UK entering a technical recession.

It added that household consumption has remained “weak” and it has seen the housing market “continue to soften”.

Read more: Bread, pasta and cooking oil price rises force millions to cut food portions

Strategists at Morgan Stanley (MS) said: "A year without surprises would be a surprise itself. Given every year comes with some…”

“A bearish outlook for the UK has pretty much been a consensus view for the past few months, and remains so even as GBP staged an impressive rally against the USD in recent weeks.”

Analysts including from Royal Bank of Canada (RY.TO) and Bank of New York Mellon (BK) have predicted that the euro will rise against sterling in the coming year.

“Euro-sterling is probably the best way to play this,” Geoff Yu, senior currency strategist at Bank of New York Mellon, told Bloomberg, adding the BOE will not hike rates as much as markets are pricing.

Meanwhile, HSBC (HSBA.L) is backing the pound being the stronger performer against the dollar in 2023.

"The USD has performed very well over the last 18 months, but a number of the forces that propelled it towards its highest valuation in decades are seen losing ground," Paul Mackel, global head of FX Research at HSBC, said.

“USD rates remain elevated compared to other currencies, but the speed of further gains is likely to slow from here.

“A bottoming in global growth dynamics alongside and a stabilisation in yields may provide a better backdrop for risk appetite, which could further weigh on the USD.”

He added: “GBP has had a very strong tie to risk appetite in recent years, and so a rebound in global sentiment will also help to boost GBP from somewhat undervalued levels.”

Watch: How does inflation affect interest rates?