It has been a difficult year for the United Kingdom for several reasons. First, as part of Europe, the UK cannot and did not remain indifferent to the war in Ukraine.
After Russia invaded Ukraine last February, energy prices surged. As a result, businesses and households across Europe suffered, including in the UK.
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Second, annual inflation rose above 10%, meaning the British pound, the local currency, depreciated. It did so mostly against the US dollar, albeit it recovered some of the lost ground in the last trading months.
Third, political instability created huge volatility in the currency and bond markets. Markets strongly rejected the mini-budget, and, as a result, the UK has a new Prime Minister, Rishi Sunak.
Fourth – Brexit. We are yet to see the full effects of it, as the pandemic and now the war in Ukraine shifted the focus from the British economy and Brexit’s impact.
To put things into perspective, one needs to look back at how the pound performed in 2022. The GBP/USD opened the year above 1.35, but then what followed was a straight decline.
During the mini-budget drama, the exchange rate dropped below 1.05, a remarkable development considering where the GBP/USD was last January. But despite the bounce back in the last months of the year, the worse may still not be over for British pound investors.
Recession is just around the corner
2023 should be a challenging year for the UK economy. According to Schroders, it is set to go into recession next year, contracting by -0.8%.
But some other forecasters see the economy shrinking by as much as -1.6% in 2023. Rishi Sunak needs to restore trust in the outlook for public finances, and hopes are that inflation will decline next year.
Naturally, the Bank of England’s actions matters the most for the currency. After hiking by 50bp at its December meeting, the Bank of England lifted the bank rate to 3.5%, following the Federal Reserve of the United States closely.
Given all these challenges, the key for the British pound investors lies with the Bank of England’s resolve in its fight against inflation and how the UK gilt yields react to Rishi Sunak’s fiscal challenges.
