“While investors remain sceptical that the Fed is particularly keen to keep hiking, the Bank of England has no choice, and so we have a combination of dollar weakness and sterling strength based on that contrasting outlook for the two. So far this seems to trump recession risk for the UK for now, which means we could see more upside from here.”
But Kingswood chief economist Rupert Thompson is less positive on the outlook for sterling by virtue of believing that the market is currently pricing in far more interest rate rises than will actually happen.
In his opinion, rates will increase in the near term as a result of wage growth continuing to be very high in the UK. “The picture so far remains one of activity stagnating rather than contracting, with [gross domestic product] unchanged in the three months to May, but a dip into recession remains a real risk,” he says.
With regard to sterling, Thompson adds: “One UK asset which has benefited from the ramping up of the expected peak for UK rates is the pound. Famous last words, but market expectations of UK rates peaking at over 6 per cent do look somewhat overblown.”
If UK rates do increase by less than expected, or the market comes to believe that this will be the case, then the likelihood is that sterling would fall in value relative to the dollar. This is because the reason for its rise in value is expectation that UK rates would increase at a faster pace than those in the US.
Economic textbooks contend that central banks should cut rates when the level of economic growth is lower than they would like, and raise rates when they fear the economy is overheating, with the latter usually evidenced by inflation being considerably above the 2 per cent target rate.
Given that the UK economy showed no GDP growth in the first half of 2023, the expectation in such a scenario would be for sterling to sell-off. This is because investors who focus on the economics of trade would anticipate sterling deteriorating as the economy is producing less, and for those who prioritise interest rates as the key, the expectation in normal times would be for rates to be cut from here to stimulate growth. This would be expected to be a negative for sterling.
But Lagarias says that while he expects recession to come to the UK this year, he believes structural issues in the economy — particularly within the labour market — mean UK inflation could persist, even in an economic downturn.
