After being one of the worst performing currencies of 2022, the Pound has staged an impressive recovery against the US Dollar, rising 15% from the depths of last September’s crisis.

After years of decline, markets are now more optimistic the Pound will continue to strengthen. But why is the Pound rising when many in the UK face a cost of living crisis? And is the Pound’s apparent recovery really as good as it looks? If we look at the value of the Pound to Euro, we can see little recovery but only a long slide and the depreciation of the past 20 years.

Why Pound Sterling Recovered in 2023

The first reason for the recovery of the Pound is that it simply performed very badly last year.

The weakest economic growth, costs of Brexit, and high Inflation all made the UK an unattractive place for investors. Then on top of that, there was the self-inflicted crisis of the Truss/Kwarteng budget which made the UK look like a badly managed emerging economy.

The reckless budget sent interest rates soaring, investors fleeing and the Pound tumbling to record lows. However, the reversal of the budget and the new Prime Minister Rishi Sunak caused some stability to return. 2022 saw a merry go round with four different chancellors and policy u-turns, by contrast 2023 has been positively calm which is helpful for Sterling.

The second reason is that in 2023 the UK economy has done better than many predicted. At the start of the year, the IMF predicted a mild recession for the UK – the worst performing economy in the G7. However, the UK has so far exceeded these – admittedly – dismal forecasts.

“Most of the data surprises are to the upside and people having to revisit their excessive pessimism.” Paul Robson, NatWest

This is not to say the UK economy is growing well. Growth in the past 12 months is just 0.6%, lagging behind the US and EU. (Most recent data showed slight fall in March 2023) Part of the reason for Sterling’s recovery is simply that it is exceeding its very dismal expectations. Currency movements can sometimes be confusing. with short-term movements often influenced by whether they do better or worse than market expectations.

The third reason is rather less encouraging. The UK’s inflation has also exceeded expectations, making it one of the highest in the OECD.

Although the Bank of England hope it will fall, it is now considerably higher than the US and EU. We might think bad news on inflation would be bad for sterling. But, in the short-term, higher inflation means that the UK is likely to raise interest rates more than expected. Last year, the Bank of England were the most doveish of Central Banks. This means they were hoping to keep interest rates low with the hope inflation would fall on its own.

But, the Banks hopes of falling inflation have been frequently wrong. And since that hasn’t happened, they are having to raise interest rates. And in the short-term, it is relative interest rates that are the key factor for determining exchange rates as Higher UK rates will attract savings and hot money flows – pushing up the Pound.

Fourthly, a lot of the Pound’s recovery reflects the dollar’s weakness this year. Post-pandemic, the dollar was strong as it had the fastest growth. But now is at a different stage of the economic cycle with US inflation falling to 4.9% (compared to 10% in the UK) and it looks like US rates won’t rise further. Also, if we look at the Sterling trade weighted index the recovery is hardly noticeable.

The fifth reason for the strength of the Pound is good news on falling gas and oil prices which will help the UK as a net importer. As a result Banks such as Natwest and Goldman Sachs have become more optimistic on the Pound stating it could recover to 1.30 dollars by the end of the year.  They point to short-term factors such as falling prices and also the more hawkish tone from the Bank of England with UK rates rising further than expected.

What about longer-term prospects of Pound Sterling?

In the short-term, high inflation and the pressure to raise interest rates have boosted sterling. But, in the long-term, relatively higher inflation will reduce UK competitiveness and reduce the value of Sterling. It is concerning that although all countries have been affected by the shocks of the past 2 years, UK inflation has often been higher than our competitors, and this is a key factor for determining long-run exchange rates. This is the significant depreciation against the Euro and reflects relatively higher inflation and lower productivity growth in the past 20 years.

In the long-term, the value of the Pound will be determined by factors such as competitiveness and the attractiveness of the economy to investors. The UK is still adjusting to the Brexit shock, with trade in goods to Europe affected by new trade barriers. More barriers are still expected to arrive.

Also, although the UK economy has narrowly avoided recession, many UK consumers may be left scratching their heads, thinking it doesn’t feel like that to them. High inflation has eroded the real value of wages and it makes the current rise in interest rates to be quite significant. Given weak household income, the interest rate increases could still hit the UK economy quite hard as hard-pressed homeowners now see rising mortgage costs. And there is a delay as people who have to remortgage fixed rate deals, get a shock when they see how bills can easily rise £200 a month.

Whilst an unexpectedly strong recovery has boosted Sterling this year. The flipside is that any unexpected slowdown in growth, would again hit the value of the Pound as interest rates would likely fall.

And the recovery of the Pound shouldn’t hide the underlying weaknesses in the UK economy. Business investment has not recovered from its post-Brexit slump, which bodes ill for long-term growth. Also, despite the Pound’s weakness, the UK is running a large current account deficit – at least for this stage in the business cycle. It is these factors which will determine value in long-term

In the long term, it is not clear that the UK has done enough to halt the long-term decline in the value of the currency. You can see in historical context, the Pound has been sliding against the dollar for the past 120 years. Brexit and the unusual political instability have created a new range of challenges for the UK economy. Traditionally, the UK was very open, relying on trade to boost growth. But, Brexit has led to a decline in trade openness. Yet at the same time, there are little signs of new growth elsewhere. The really worrying thing for the UK economy is when, if ever, we can see a renewed growth in productivity, the driving force for higher economic growth.

On a more optimistic note, there are signs that exports of services are doing better than expected, possibly due to services being less affected by leaving the single market than goods. Also, the fact the UK avoided recession, despite the weight of bad news is somewhat encouraging. Also, the worst of Brexit political instability may have passed which would be good for sterling.

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• Factors which influence the exchange rate