GBP tipped to struggle in Q1But broader recovery to take holdGBP/USD could go as high as 1.30GBP/EUR to remain relatively rangebound

Above: Prime Minister Rishi Sunak has steadied the political environment, a potentially positive theme for GBP in 2023. File image by Simon Walker / No 10 Downing Street.

Peak pessimism towards the British Pound may be close to passing says a year-ahead research publication from MUFG, the global investment bank and lender.

The Pound was the third-worst performing major currency of 2022 but stabilisation in gas prices and a more settled domestic political picture are among the factors setting the scene for gains in the coming months.

"Our sense as we enter 2023 is that we may have reached or will soon reach peak pessimism," says Derek Halpenny, Head of Research for Global Markets EMEA at MUFG.

Near-term Weakness...

The Pound retains an elevated correlation to the performance of global markets, tending to rally when investors are in an optimistic mood. But, any setback to sentiment tends to result in a lower Sterling, as has been the case in the early stages of the year.

Markets remain heavily focused on U.S. data and speculation as to how the Federal Reserve will approach interest rates over the coming year.

The consensus expects the Fed to end the hiking cycle in the first quarter, which would underpin global sentiment and the Pound as businesses and consumers see a stabilisation in the cost of borrowing.

Above: GBP is the worst-performing major currency when screened over a one-month period. Consider setting a free FX rate alert here to better time your payment requirements.

Forward-looking markets even see the potential for an interest rate cut towards the end of the year as the Fed is predicted to ease monetary conditions on account of a notable slowdown in the U.S. economy.

But for now, the Fed will not want to see financial conditions loosen prematurely lest inflation gains a foothold and could therefore be keen to push back against markets.

Data will remain volatile and assist the Fed in their hawkish messaging, meanwhile, a slowdown in the U.S. and global economies raises the prospect of a disappointing series of corporate earning seasons ahead.

This threatens market volatility and to create conditions that tend to leave the Pound struggling.

... Gives Way to a More Enduring Rally

"We get a sense that we are close to peak pessimism in the UK," says Halpenny.

"Better conditions globally (subsiding inflation) and domestically (recession-end to approach later in the year) should allow for a period of GBP outperformance," he adds.

As the new year gets underway the consensus expects the UK to suffer the worst recession of the G10 economies, denying the Pound a fundamental source of demand.

Economists routinely cite elevated inflation levels, subdued consumer sentiment, fiscal tightening, strikes and rising interest rates for such expectations.

Above: "UK faces longer recession than other developed markets" - J. Safra Sarasin.

"The energy pass through to utility bills has been more severe than in many countries in the euro-zone," says Halpenny.

As a result of a subdued economic outlook foreign exchange markets entered 2023 with a negative stance on the British Pound, confirmed by the following data that finds Sterling to be a consensus sell in 2023:

Above: The GBP is a consensus sell in 2023. Image courtesy of Spectra Markets.

The Pound could benefit if the UK economy confounds expectations and analysts at Morgan Stanley say GBP outperformance is one of their top ten surprises they are on the lookout for in 2023.

Oliver Rust, head of product at independent inflation data aggregator Truflation, says there is potentially too much negativity being heaped on the UK economy at this point.

"The UK is certainly in a tough spot, but whether it will suffer more than any other economy in the G7 - and as much as Russia - I am not sure. Many European countries and also Japan are facing similar challenges and it seems unlikely the UK will be significantly worse off," he says.

MUFG reckons there are a number of factors that could see GBP turn a corner:

The blowout in the UK trade deficit has halved from its nadirEnergy price declines point to a further improvement in the trade deficitA resolution to public sector strike actions looks more likely than notThe new government has adopted a credible plan to deal with the country's financesProgress continues to be made with the EU on the outstanding issues concerning the Northern Ireland protocolFinally, political certainty is set to make a return following a tumultuous 2022 that saw three Prime Ministers occupy 10 Downing Street.

"PM Sunak looks to have restored some order and credibility to the office of PM after his two predecessors and our sense as we enter 2023 is that we may have reached or will soon reach peak pessimism and this year could be a year of better sentiment toward the UK," says Halpenny.

MUFG forecasts the Pound to Dollar exchange rate to slide back to 1.1410 by the end of the first quarter, recovering to 1.2180 by the end of the second quarter, extending to 1.2410 by the end of the third quarter and crossing the psychologically significant 1.30 level by year-end.

Their Euro to Pound exchange rate forecasts for this time period are 0.8850, 0.8700, 0.8700 and 0.8600.

This gives a Pound to Euro profile of 1.13, 1.15, 1.15 and 1.16.

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