Bank of America: UK economic vulnerability, risk aversion and dollar revival will trigger GBP/USD losses in Q1 to 1.12

According to Bank of America, persistent inflationary pressures will force central banks to maintain higher interest rates for longer, which will undermine risk appetite and strengthen the dollar.

The bank also sees UK pessimism as justified and predicts that the Pound Sterling to Dollar (GBP/USD) exchange rate will fall to 1.12 at the end of the first quarter.

GBP/USD was trading near 1.2175 on Friday, having retreated from 4-week highs at 1.2250.

UK pessimism justified, biggest drop in disposable income in 60 years

Bank of America maintains a negative stance on the UK economy. While the political outlook has stabilized and financial stability has been restored, the bank still believes global sentiment remains negative.

According to BoA: “UK asset markets have been reassured by the UK Budget and the overall approach of the new UK Prime Minister and Chancellor. Nevertheless, investors remain very skeptical about the outlook for the UK economy and, as a result, the British pound sterling.”

The Bank is focusing on the hit to consumer spending from further increases in retail energy prices, as well as wider inflationary pressures. In this context, it believes global mistrust of sterling is justified.

BoA adds: “To a large extent we understand: our economists expect a recession in the UK, predicting the biggest fall in real disposable income since at least the mid-1950s.”

The BoA is also concerned that general inflationary pressures will reduce consumers’ purchasing power.

The bank adds: “While core inflation has probably peaked, they expect underlying inflationary pressures to persist.”

BoA expects the euro to pound sterling (EUR/GBP) exchange rate to end the first quarter at 0.89 (1.12 for GBP/EUR).

The dollar will regain ground amid risk aversion

While the BoA expects the pound to remain vulnerable, a key element of the outlook is that the bank expects the dollar to regain ground.

The bank expects inflationary pressures to persist, forcing the central bank to maintain a hawkish stance until there is clear evidence that inflation is retreating towards 2%.

The bank adds: “We would particularly emphasize the strong commitment of central banks to tackle high inflation.”

The BoA also expects central bank policy tightening to increase recession risk: “Tight monetary policy during a recession is something that markets have not seen since the 1980s and, in our view, cannot appreciate at present (bad news for the economy will be bad news for markets).”

The bank also points to financial stability risks. In BoA’s view, “All of this tells us that the market euphoria since mid-October may be overdone.”

A lower risk appetite would boost the dollar and lead to new vulnerabilities for the euro and pound.

BoA forecasts show that the euro/dollar exchange rate (EUR/USD) will return to parity at the end of the first quarter.