Capital Economics release dire predictionsThis will be GBP's biggest crisis to dateGBP/USD faces record lowsBut GBP/EUR to stay steady

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The British Pound is forecast to plumb record lows against the U.S. Dollar in 2023 as a seemingly inexorable decline continues into coming months, but against the Euro the UK currency looks better supported.

This is according to new projections and research released by Capital Economics, an independent research provider, which shows the 'cost of living crisis' will be Sterling's most severe.

"If we are right in expecting the UK economy to contract by around 1% at the same time as high inflation prevents the Bank of England from providing any support, then the pound probably has further to fall. Our forecast is for sterling on a trade-weighted basis to depreciate by a further 5% by the end of 2022," says Paul Dales, Chief UK Economist at Capital Economics.

The call comes at a time of significant selling pressure for the Pound which has this week fallen to its lowest level against the Dollar since March 2020, a time when markets were gripped by Covid panic.

The Pound to Euro exchange rate is 1.78% lower this week alone, at 1.1572, taking bank account quotes for euro payments to around 1.1167 and quotes at independent providers to around 1.1537. The Pound to Dollar exchange rate is down 1.56% this week, taking bank account quotes for dollar payments to around 1.1320 and quotes and independent providers to around 1.1520.

Much of the decline has been powered by the relentless rise in the value of the U.S. Dollar, with the Bloomberg Dollar index hitting a record high on September 01.

But, Sterling's weakness is evident against other major currencies, including the Euro, confirming a distinct UK-centric flavour to the selling pressure.

"We think the UK has fallen into recession, while the US may avoid one. If anything, the recent surge in UK wholesale gas prices suggests that the risks are tilted towards a deeper and longer recession in the UK," says Dales.

The Dollar's rampant ascent also comes amidst an ongoing decline in 'risk assets', most evident in the decline of global stock markets.

Investors fear a significant global economic slowdown is underway amidst the combination of war in Europe, China's stubborn insistence on 'zero covid' and the Federal Reserve's excruciating interest rate hikes as it battles to cool inflation.

Where the Dollar is a beneficiary in times of global investor panic, the Pound tends to be a loser. If you are concerned about current FX rate movements, you can consider locking in today's exchange rate for future use, to protect against adverse movements, learn more here.

"We now anticipate a mild recession globally. The resulting fall in risk appetite will hurt the pound which, because of the UK’s large current account deficit, tends to behave more like a risky asset than a safe haven," says Dales.

Above: GBP/USD & UK Less U.S. 1-Year Rate Expectations. Image courtesy of Capital Economics.

Bank of England policy and UK interest rates will also likely prove unsupportive for Sterling, according to Capital Economics.

"Relative rate expectations will be a headwind for sterling against both the dollar and the euro," says Dales.

Above: GBP/EUR & UK Less EZ 1-Year Rate Expectations. Image courtesy of Capital Economics. Don't miss your ideal exchange rate, set a free alert here.

The Bank of England is expected to raise interest rates by a further 50 basis points in September with markets anticipating the peak for Bank Rate towards 4.30% by 2023.

In fact, money markets now show investors expect more interest rate hikes from the Bank of England over the remainder of 2022 than any other major central bank, a reflection of the UK's excruciatingly high inflation rates.

The ability to deliver an expected ~180 bp of hikes by year end is questionable as it implies at least one 75 basis hike from the Bank before the year is out. Judging by Sterling's ongoing poor performance it would appear the currency market has long decided the Bank will be unable to meet these expectations.

Above: Market expectations for the future of Bank of England's Bank Rate. Derived from 3-year Forward Expectations. Image courtesy of Goldman Sachs.

"We think UK interest rates will rise by much less than money markets now discount, but that investors are broadly correct about the degree of tightening required in the euro-zone and the US," says Dales.

Given the above expectations, Capital Economics now thinks the Pound will fall to below the levels reached before the 1985 Plaza Accord ($1.09), after the UK left the Exchange Rate Mechanism in 1992 ($1.43), during the 2008/09 Global Financial Crisis ($1.38), after the 2016 Brexit vote ($1.21) and during the 2020 COVID-19 crisis ($1.21).

The Pound to Dollar exchange rate is forecast to fall to 1.05 by mid-2023, "in fact, $1.05 would be an all-time record low," says Dales.

Capital Economics thinks the Euro-Dollar rate will fall to a trough of 0.90.

The Pound to Euro exchange rate is meanwhile projected at 1.17 by mid-2023, confirming there might be little to differentiate the Euro from the Pound.

Elsewhere, the FTSE 100 is forecast to fall by about 10% to 6,700 between now and the end of 2022.

"The risk is that the UK recession is deeper than we expect and UK equity prices fall further," says Dales.