What is the outlook for sterling?

While the value of a currency in absolute terms is impacted by factors such as GDP performance and the balance of payments, in relative terms, the performance of sterling more recently has been closely aligned with market expectations around monetary policy, specifically the pace and extent of rate rises or cuts. 

Expectations of rate cuts reached a peak in the final quarter of 2023 as central banks signalled a “pivot” away from the previously tight monetary policy may be on the way, as inflation fell. 

Lower rates are regarded by economists as being positive for economic growth but also contributing to inflation, since lower returns for savers and lower interest payments incentivise spending. 

Amundi head of global currency management Andreas Koenig says: “Last year sterling was stuck in a situation of slightly contradicting forces. On the one hand, the difficult economic situation was a burden for the currency, whereas the high interest rates supported sterling on the other hand.

“One main strategy in 2023 was ‘carry’ [owning an asset specifically to collect the available income]. This factor supported sterling as it is one of the highest yielding currencies in the G10. But the carry strategy is not as much in focus now as it was last year. Therefore, less support comes from this, and the strong US dollar has brought [sterling lower against the dollar] lately.”

Last year sterling was stuck in a situation of slightly contradicting forces. On the one hand, the difficult economic situation was a burden for the currency, whereas the high interest rates supported sterling on the other handAndreas Koenig, Amundi 

One of the reasons the dollar has been strong against an array of currencies this year is that markets have begun to reprice sharply their expectations on US rates.

At the end of December, markets were pricing in around seven rate cuts for 2024, though that number is now closer to two as a result of inflation being more persistent and growth more robust in the US economy than had been forecast, according to Zurich head of macroeconomics Guy Miller.

This has had a negative effect on sterling, since one of the reasons the currency was strong against the dollar in 2023 was that investors expected inflation to remain persistently higher in the UK relative to other developed markets, preventing the Bank of England from cutting rates.

That divergence of opinion on the future direction of rates created the carry position described by Koenig above.

Winding roads

Abrdn investment director for fixed income Luke Hickmore says the strength of the dollar may be a relatively short-term phenomenon.

He says: “In the short term, US dollar strength feels more related to its haven status in volatile geopolitical events. The Fed will be slower to cut rates than the Bank of England or the [European Central Bank]. However, over the medium term [into 2025] they will likely be cutting, and any support for the US dollar from higher rates will fade.” 

Hickmore does, however, feel that the strong performance of the dollar relative to sterling over the longer term could be impacted by more traditional factors, such as the relative strength of the US economy compared with the UK economy.