"Although the economy has proved resilient to the cost of living crisis, which is coming to an end, we think the cost of borrowing crunch will send it over the edge" - Capital Economics.

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The "cost of borrowing crunch" will send the UK economy and the currency into reverse as we move through the second half of the year, according to an analysis from a leading independent research provider.

Capital Economics says the UK economy and the Pound have held up better than they, and the consensus, had expected at the start of the year, but the rise in UK interest rates and the associated pullback in demand will have an acute impact going forward.

"Although the economy has proved resilient to the cost of living crisis, which is coming to an end, we think the cost of borrowing crunch will send it over the edge. The drag on activity from higher interest rates is the main reason why we think real consumer spending and real private investment will fall," says Paul Dales, Chief UK Economist at Capital Economics.

Above: Capital Economics' estimate of influence on Real GDP of rise in interest rates from 0.10% to 5.25%.

We report these findings on the day two-year fixed mortgage rates at some of the UK's leading lenders cross the 6.0% level in what will prove a shock to hundreds of thousands of homeowners forced to renew their mortgages over the coming weeks and months intensifies.

Driving the rise in mortgage rates and the cost of borrowing more generally is the ongoing rise in UK bond yields that has seen the two-year bond now yield more than 5% for the first time in 15 years.

The rise in yields comes as markets see higher interest rates at the Bank of England which continues to take steps to bring inflation in the UK lower.

For now, this rise in UK bond yields relative to the Eurozone, U.S. and elsewhere is proving a supportive force for the Pound which is 2023's top-performing currency as we reach the mid-point of the year.

The Pound to Euro exchange rate rose to its highest level since August 2022 on Monday at 1.1738 as UK short-term yields extended a march higher. The Pound to Dollar exchange rate meanwhile hit its strongest level in more than a year at 1.2848 last Friday.

But for Capital Economics analyst Jonas Goltermann, the supportive dynamic between rising yields and the Pound's value could shift if the UK economy slips into recession over the coming weeks.

"We doubt sterling’s strong run will continue; we still think that an economic downturn in the UK and other advanced economies will lead to renewed downward pressure on sterling later this year," he says.

Money market pricing shows at the current time investors are positioned for a peak in Bank Rate at around 6.0%.

Above: Real GDP and Bank Rate.

But Capital Economics says Bank Rate won't get this high, pencilling a rise from the current 4.75% to a 5.25% peak. Yet, this will still be enough to deliver recession.

"As the UK's recent problem of higher inflation and slower economic growth than elsewhere is largely due to the lingering effects of the pandemic and Brexit, we think the UK will probably look like the stagflation nation for another couple of years yet," says Dales.

"Unlike most other forecasters, we still expect that the rise in interest rates will trigger a recession in the UK, and that this is necessary to reduce inflation to 2.0%," he adds.

Capital Economics now thinks the recession will start later than previously thought (the second half of this year rather than the first) and be smaller (a peak-to-trough fall in real GDP of 0.5% rather than 1.0%).

UK inflation is particularly elevated owing to the frantic pace in wage rises, something Capital Economics says can be blamed on job mismatches caused by Brexit and the bigger hit to the UK’s labour supply since COVID.

Yet, Capital Economics reckons wage growth is unlikely to slow to rates consistent with the inflation target without the unemployment rate rising from April’s 3.8% to 4.5%.

The economic slowdown means Capital Economics is forecasting CPI inflation to fall from 8.7% in April to the 2.0% target by the first half of 2024 and that core CPI inflation will decline from 6.8% to 2.0% by early 2025.

A 6.0% peak in Bank Rate is an expectation unlikely to be met says Goltermann, and the grounding in expectations would mean a mechanical unwind of the recent strength seen in Pound Sterling.

"We think the path of UK interest rates now discounted in the money market is considerably higher than the policy path that the BoE will end up delivering," he says, adding:

"Sterling will weaken sharply against the dollar and, to a lesser extent, against the euro later this year."

Capital Economics forecasts the Pound-Dollar exchange rate will be at 1.21 by the end of September, slide to 1.15 by the end of the year, recover to 1.18 by the end of March 2024 and 1.20 by the end of June 2024.

For Pound-Euro, the respective point targets are 1.16, 1.15, 1.14 and 1.13.