Sterling faces economic headwinds and election uncertainty despite stellar year

Despite Sterling's remarkable performance against the Dollar in 2023, marking its best year since 2017, economic challenges and looming election uncertainties pose hurdles for a repeat performance.

The resurgence of confidence in Britain's currency was evident as it rebounded from a record low just 16 months ago, fueled by better-than-expected economic performance, Bank of England's cautious approach to monetary easing, and a weakened appeal of the U.S. Dollar amid expectations of an early rate cut.

Trading near $1.28, the pound recorded an impressive 6 per cent gain against the Dollar last year, securing its position as the second-best performing major currency after the Swiss franc.

However, as the UK heads into a potential election year, the drivers behind Sterling's rally are losing momentum, raising concerns about its sustainability.

One factor contributing to the weakening momentum is the diminishing impact of interest-rate differentials, a significant factor in the global currency market. The perception that the Bank of England would lag behind the European Central Bank and Federal Reserve in policy easing has been challenged by recent economic data.

The UK's consumer price inflation eased to 3.9 per cent in November, and the GDP was revised downward to show a 0.1 per cent contraction in Q3, suggesting potential challenges for the British economy, possibly even a recession.

The changing economic landscape prompted market expectations of a BoE rate cut to be brought forward, with a 25 basis point cut fully priced in as early as May, compared to the previous expectation of August.

Jane Foley, Head of Currency Strategy at Rabobank, notes that without higher inflation or stronger growth, the pound may struggle to surpass $1.30, adding complexity to its upward trajectory.

Sterling, traditionally viewed as a "risk currency," is susceptible to global economic dynamics, particularly in line with equities. Its recent gains coincided with MSCI's world stock index reaching two-year highs. However, if global stock markets experience a reversal, it could pose a risk for the pound.

Dominic Bunning, HSBC's Head of European Currency Research, believes Sterling's recent rally was unjustified from the perspective of interest rate differentials and expects a potential weakening towards $1.20 this year due to British economic weaknesses.

Another potential source of instability is the looming British election, expected this year, with polls favoring the opposition Labour Party. The election's timing could influence the timing of rate cuts by the BoE to avoid appearing as an influence on the country's mood around election time.

While some uncertainties lie ahead, not all forecasts anticipate Sterling weakness. Global economic uncertainty has resulted in less consensus among forecasters compared to the previous year. Goldman Sachs, for example, envisions the pound at $1.35 in 12 months, citing calmer government bond markets and high equity prices as potential factors boosting Sterling's performance.

(With Reuters inputs.)