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The British pound had its worst monthly performance against the U.S. dollar in 12 months during September, sliding 3.75% as expectations for UK economic growth continued to deteriorate. Sterling also dropped 1.26% against the euro, marking its weakest showing since December 2022.

The pound’s slide reflects a “re-evaluation of expectations” for the peak in UK interest rates, according to Jane Foley, chief FX strategist at Rabobank. Markets now see rates peaking at around 5.25% after the Bank of England paused its aggressive tightening cycle last month, keeping its key rate unchanged after six consecutive hikes.

This shift in rate expectations has undermined the pound against the greenback. Meanwhile, recessionary risks are mounting for the UK economy compared to the euro zone, keeping sterling relatively weak against the common currency.

“The Bank of England is, amongst the G10 central banks, probably in the hardest position,” said Jim McCormick, macro strategist at Citi. “They need to balance an increasingly weaker growth outlook with very sticky high inflation. I think part of sterling’s weakness is less pricing for Bank of England going forward, I think part of it is this recognition of low growth and high inflation, and I do expect sterling to weaken further from here.”

Pound Falls to New Lows Against Strong Dollar

The pound dropped to lows near $1.03 against the U.S. dollar this summer during a period of political instability in the UK. While it has recovered from those extremes, sterling remains stuck near multidecade lows against the greenback.

The dollar has surged across the board this year as the Federal Reserve has hiked rates aggressively to combat high inflation. Upbeat economic data has also boosted the U.S. currency. This has weighed on sterling despite the Bank of England’s efforts to rein in price pressures.

“When U.K. interest rates are eventually cut late in 2024, we suspect rates will be reduced further and faster than investors expect,” noted economists from Capital Economics. They forecast the key rate falling back to 3% in 2025 compared to current market expectations of 4.5%.

Goldman Sachs strategist Michael Cahill also predicts further losses for the pound, seeing scope for a drop below $1.20. He cites the Bank of England’s recent dovish policy tilt emphasizing growth over inflation fighting.

“Either they add less restriction over time because they allow for more inflation tolerance, or the recent cyclical data are a genuine sign of more of a cyclical downturn than we think. Both are negative for the currency,” Cahill explained.

Economic Growth Forecasts Cut Amid Recession Risks

The pound’s underperformance partially reflects the UK’s weaker growth profile compared to the U.S. and Europe. The Bank of England expects the economy to expand just 0.5% this year while the OECD predicts 0.3% growth.

That compares to forecasts of 1.5–1.9% expansion in the U.S. and 0.7% euro zone growth. The UK faces rising recession risks as high inflation squeezes consumers and businesses.

Retail sales have stalled, consumer confidence is at record lows, and businesses are cutting back on investment. Government support has cushioned the blow so far, but aid programs are now winding down.

“The outlook for GDP growth in the UK has weakened. There are increasing signs that higher inflation and interest rates are weighing on spending while rising costs continue to squeeze business margins,” said Suren Thiru, economics director at the British Chambers of Commerce.

The weak growth outlook makes it harder for the Bank of England to continue hiking rates without triggering a deeper downturn. As a result, monetary policy is now seen to be on pause after a series of large rate increases this year.

In contrast, the Federal Reserve and European Central Bank have more room to keep tightening as their economies hold up better. This divergence in central bank outlooks has amplified sterling’s woes.

Inflation Still Sticky Despite Energy Price Relief

UK inflation remains elevated at 9.9%, far above the Bank of England’s 2% target. Prices are rising faster than wages, crimping real incomes. But inflation may have peaked thanks to relief on energy bills.

“We expect CPI inflation to peak at 11% in October when the next increase in the energy price cap hits households,” said chief economist Hugh Gimber of global investment firm abrdn.

The government’s intervention to cap household energy bills will help contain inflation. However, the BOE expects inflation to stay above 10% for several months and only slowly return to target by late 2024.

Sticky inflation and weakening growth put the central bank in a tough spot. Further rate hikes risk recession, but premature easing could entrench inflation. This policy quandary leaves the pound vulnerable.

Outlook Remains Gloomy on Recession Worries

Most analysts expect sterling to remain on the backfoot as the economic backdrop deteriorates. Tightening monetary policy globally to fight inflation will continue weighing on growth.

“The outlook for the pound is poor. The economy is expected to enter recession later this year or early 2023 and remain there throughout much of next year too,” warned economist Rupert Thompson of Kingswood Holdings.

Until the growth picture improves, the pound may struggle to regain its footing. Any signs of stabilization in the UK economy or a pivot in BOE policy could spark a rebound. But for now, the currency remains under the cloud of recession risks.

With the Fed and ECB likely to continue tightening for longer, dollar and euro strength may persist versus the pound. Sterling faces an uphill battle with the cards stacked against the ailing UK economy.