From Political Turmoil to Inflationary Pressures – GBP to USD Forecast 2023

It was a year for the GBP to USD bulls to forget. UK politics, the War in Ukraine, inflation, strikes, and the Bank of England sent the GBP/USD to a historical low before political stability and monetary policy restored order.

Surging energy prices drove inflation to the highest level in 41 years, forcing the BoE to take aggressive steps to prevent inflation from becoming entrenched. However, a failed mini-budget and the ousting of the UK chancellor and Prime Minister sent the GBP/USD to an all-time low of $1.03565.

The writing had been on the wall before political catastrophe hit the Pound, with a more aggressive Federal Reserve driving demand for the dollar.

While the GBP to USD recovered from its September low, the Pound ended the year down 11.4% to $1.20857. A hawkish Bank of England, political stability, and a palatable Autumn budget were the key to the GBP return to $1.20.

Softer inflation figures across the pond also led to a pullback in the dollar on Fed pivot bets.

Despite the GBP/USD return to $1.20, the Pound remains at risk of another sharp decline in 2023. Certain factors will likely dictate the movements of the GBP/USD throughout the year.

Bank of England Monetary Policy and UK Economy

In November, the Bank of England warned that the UK is facing its most prolonged recession since records began. The warning came following a 75-basis point rate hike in November. Economic woes did not deter the Bank from hiking interest rates by another 50 basis points in December.

In December, the Bank of England Financial Stability Report noted that the UK economic outlook and unemployment had deteriorated since the July report. Rising interest rates have made it more challenging for households to repay debts. While the BoE viewed households to be in a better position to service household debt, conditions may deteriorate rapidly.

A sharp rise in unemployment would adversely affect spending power and impact household debt servicing capabilities. Lower spending would impact the services sector and send the UK economy into a deeper recession.

High energy costs and policy tightening would further exasperate the economic outlook and sink the Pound.

Global Macroeconomic Environment a Key Influence on the GBP to USD

The global economic outlook deteriorated in H2 2022, adding downward pressure on the GBP/USD. Pound sensitivity to macroeconomic headwinds will likely intensify in 2023. Economies will feel the effects of Fed monetary policy, with a global economic recession negative for the Pound.

In September, the IMF and the World Bank warned of the risks central banks pose to the global economy.

On this basis, a deteriorating macroeconomic environment would impact the GBP/USD further in 2023.

UK Political Stability and the Bond Markets

In late 2022, political order appears to be restored, with Jeremy Hunt as Chancellor and Rishi Sunak as British Prime Minister. However, both have only been in office for several months, and recent history suggests that no Prime Minister or Chancellor is safe.

The September market rout that hit UK Gilts and the Pound led to the ousting of Chancellor Kwasi Kwarteng and, eventually, Prime Minister Liz Truss.

For the GBP/USD to have a bullish 2023, political stability is a must. Investor confidence in the UK government would support capital inflows at current valuations to deliver Pound support.

Bad press and calls for a vote of no confidence or an early General Election would likely sink the Pound and erode any confidence restored since the Autumn budget.

Free of scandal, addressing the current account and budget deficits is needed, as these continue to deliver GBP uncertainty. The UK bond market is another concern for the Pound, with supply and inflation leaving gilts at risk.

The Fed Remains in the Driving Seat

Recent US inflation figures indicate that inflation may have peaked, allowing the Fed to take its foot off the gas. The shift in sentiment delivered dollar weakness, allowing the GBP/USD to reduce its deficit for the year.

While the last FOMC projections were hawkish, CPI reports in early 2023 could decide the fate of the GBP/USD through H1 2023. An unexpected pickup in inflation would force the Fed to stick to its projected interest rate trajectory and push rates higher for longer.

High rates could force a deeper global economic recession and a hard landing that would drive demand for the dollar.

In contrast, softer inflation numbers would allow the Fed to take its foot off the gas and deliver a soft landing. Dollar weakness would prevail though any downside would likely be affected by the global macroeconomic environment.

The other question will be when the Fed reverses policy to support an economic recovery. Likely through H2 2023, the focus will shift to the Fed and the BoE loosening monetary policy to address the threat of prolonged economic recessions.

Again, this could be an area for dollar weakness, with the Fed likely to pivot ahead of the BoE. However, the macroeconomic environment would dictate the impact on the GBP/USD. Deep global economic and UK recessions would leave the dollar in the driving seat and the GBP/USD under pressure throughout H2.

While inflation will be the focal point, market participants should also consider US labor market conditions. Resilient labor market conditions would force the Fed to lift rates higher to bring unemployment towards the 5% target. Currently, the US unemployment rate sits at 3.7%, giving the Fed plenty of wriggle room to tackle another inflation spike.

GBP to USD Curve Balls

• War in Ukraine – prolonged energy crisis (GBP negative).
• COVID-19 China/Global Response to surge in new cases (USD positive).
• Russia-China alliance – Taiwan, geo-political instability (USD positive).
• UK Political Instability – Call for a vote of no confidence or early general election (GBP negative).
• Strikes – Continued strike action would affect the economy and sentiment (GBP negative).

GBP to USD Best, Worst, and Base Case Scenarios for 2023

Several outcomes are possible when considering the factors that could impact the GBP/USD in 2023.

Base Case:

• Inflation softens further in January and February.
• The UK and the US experience mild and short-lived recessions.
• Softer inflation allows the BoE and the Fed to take their foot off the gas in Q1.
• War in Ukraine continues, but Russia shows no sign of escalating its offensive.
• China holds back from forging stronger ties with Russia, and Taiwan remains a hotly debated topic.
• COVID-19 surge runs out of steam, removing the fear of new strains and fresh restrictions to prevent a global spread of the virus.

GBP/USD returns to $1.30, with a possible look at $1.35 on improving economic conditions in H2 2023.

Best Case:

• Inflationary pressures crumble on weak demand through January.
• Fed and the BoE hit ‘pause’ on interest rate hikes to limit economic fallout. Possible Fed talk of interest rate cuts in H2 2023.
• The war in Ukraine ends, and Russia removes all supply restrictions to end the energy crisis.
• UK to return to growth in Q4 2023.
• New COVID-19 strains are less virulent and less of a health hazard than the flu.
• China remains on the sidelines vis-à-vis Russia and focuses on rebuilding its economy rather than on Taiwan.
• The political landscape improves further, with the Tory Party successfully navigating the current political and economic storm.

GBP/USD moves through the 2022 high of $1.37488 to target the $1.40 handle.

Worst Case:

• Inflationary pressures reignite, forcing the BoE and the Fed to push ahead on aggressive interest rate trajectories.
• Economies fall into deep recessions, leading to a marked increase in unemployment rates.
• The war in Ukraine intensifies, with China and Russia forging a political alliance.
• COVID-19 strains are more virulent than the Delta strain, forcing governments to shut borders to control the spread of the virus.
• UK Government comes under renewed fire, fueled by a collapse in the UK economy, bond market volatility, and a slump in the Pound.

GBP/USD slides through the 2022 low of $1.03565 to bring parity into play.