Analyzing the Factors Behind the Recent Decline of the British Pound

The pound has recently hit a six-month low against the US dollar, primarily due to expectations of the Bank of England ending its interest rate hikes and the resilience of the US economy. Sterling has fallen to $1.215, a significant drop from its peak of over $1.31 in July.

This decline in the currency represents a decrease of more than 3% against the dollar this month, making it one of the worst months for the pound since the aftermath of last year’s mini-budget. However, it’s worth noting that the pound remains much stronger than its low of $1.068 seen a year ago after Liz Truss’s fiscal statement triggered a bond market crisis.

Analyzing the Factors Behind the Recent Decline of the British Pound

The weakening pound could pose challenges by contributing to inflationary pressures and potentially hindering Rishi Sunak’s goal of halving inflation by the end of the year.

The primary factor behind the pound’s weakness is fluctuating interest rates. When interest rates rise, global investors are attracted by higher returns, which leads to an increase in the currency’s value. The pound reached its peak against the dollar in July when the Bank of England was aggressively raising interest rates, while it was believed that the US Federal Reserve was about to halt its rate increases. This caused investors to shift from the dollar to sterling.

However, changing economic indicators, such as a cooling job market and a surprise drop in inflation, have forced traders to revise their assumptions. The Bank of England’s recent decision to keep rates unchanged for the first time in almost two years has led the market to believe that borrowing costs have reached their peak at the current 5.25%.

Sandra Horsfield, an economist at Investec, attributes much of the pound’s underperformance to these shifting interest rate expectations. Previously, markets had expected the Bank rate to reach nearly 6.5%, but those expectations have now significantly lowered.

Additionally, the strength of the US dollar is contributing to the pound’s weakness. The euro, unaffected by the Bank of England’s actions, has also declined against the dollar, highlighting the overall strength of the US currency.

The dollar’s strength is fueled by the Federal Reserve’s projections of maintaining US interest rates above 5% next year, contrary to earlier forecasts of a reduction to around 4.6%. These projections also indicate steady economic growth in the US, whereas the Bank of England expects slower growth for the UK.

In relative terms, the pound has depreciated more than the euro, in part because it outperformed the euro earlier in the year, leaving more room for decline.

Analysts at Nomura and Goldman Sachs predict further depreciation of the pound, possibly to $1.18, the lowest level since February. They attribute this weakness to declining foreign investment in the UK, fund outflows, and the conclusion of the Bank of England’s rate hike cycle. The hawkish stance of the Federal Reserve and the strength of the US economy are expected to support the dollar.

A substantial improvement in British economic data would be necessary to reverse this trend, but such a shift would likely take time to materialize.

This situation has negative implications for the UK, particularly in terms of higher import costs and the challenge of controlling inflation, especially as oil prices rise. Brent crude, priced in dollars, has surged by nearly one-third from its June low, which will impact British consumers at the pump.

The combination of a weaker pound and rising oil prices could slow down the rate at which inflation decreases, adding financial strain as a significant portion of the UK’s £2.6 trillion national debt is linked to inflation, resulting in higher annual debt interest costs.

The decline in the pound’s value comes at an inconvenient time for Prime Minister Jeremy Hunt and Chancellor Rishi Sunak, as it makes their goals, such as tax cuts in the November Budget, more challenging to achieve. This could further complicate their upcoming election campaign