The Bank of England
The pound has lost ground to most of its key rivals this past year (c/ Charlie Bibby/FT).

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A pair of Wall Street banks are warning about the “grim outlook” for the pound. They predict that stubbornly high inflation, and an economic slowdown, will lead to further declines in the currency. The pound has lost ground to most of its key rivals this year despite four rises in UK interest rates since December, when the Bank of England began tightening monetary policy ahead of the major central banks. The sharpest losses have come over the past six weeks as investors grow increasingly concerned about a cost of living crisis, which the BoE cautioned could push the UK into recession later in 2022.

Sterling has steadied recently as a broad dollar rally goes into reverse, but remains close to the lowest level since early 2021 against a basket of currencies of the UK’s trading partners. A Bank of America investor survey revealed that sterling sentiment dropped sharply in the last month. This abruptly ended a period of relative optimism about the currency.

“Sterling’s fall from grace has been epic given last year’s euphoria and in many ways has caught the investor community by surprise,” said Kamal Sharma, a currency strategist at Bank of America. “Hiking rates against a sharply slowing economy is never a good look for any currency.”

Line chart of Sterling effective index showing Pound falls against currencies of major trading partners

A pause in the global dash to the dollar, along with last week’s PS15bn package to support UK households battered by climbing energy prices, “may provide some relief but the damage has been done and the outlook for the pound looks grim”, Sharma added. The BoE’s lead in tightening monetary policies has increased the gap between bond yields in the UK and other economies, including the eurozone where interest rates are still rising. According to Vasileios Gionakis, Citi’s head for currency strategy, sterling’s tailwind is set to diminish as the European Central Bank plays catch up.

” The ECB has made a significant hawkish shift, but the BoE will still be between a rock-and-a-hard place due to high inflation, and a sharply slowing economic environment,” stated Gkionakis. He is forecasting a rise in euro prices above PS0. 90 later this year, from the current level of PS0.852.

Sterling could be at risk if the UK continues to threaten to end the post-Brexit trade agreement for Northern Ireland, Gkionakis said. The currency rose as high as $1. 42 a year ago as investors warmed to sterling in the aftermath of the signing of the UK-EU Brexit trade deal in December 2020. Since then, it has fallen to $1. 26, but the losses could quickly accelerate to take the pound to parity with the greenback if the Northern Ireland dispute escalates into a trade war with the EU, according to Gareth Colesmith, head of global rates and macro research at Insight Investment. Colesmith stated that it could happen if the UK government does not lie about Northern Ireland and pulls the plug. The US side with the EU is also possible.

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