The British economy is currently grappling with significant challenges, including the looming risk of recession, which directly impacts the value of the British poundAs fiscal and monetary policies face underlying contradictions, the pressure on the pound's depreciation is likely to escalate in the medium term.

Since September, fluctuations in the pound's exchange rate have intensified, showing signs of nearing parity with the dollar before experiencing a volatile reboundThe causes behind this dramatic variability in exchange rates raise questions about the future trajectory of the pound.

Since mid-September, the divergence between the pound's exchange rate and the yield spread of UK government bonds has markedly widenedDespite the widening spreads between UK and US bonds, this has not provided effective support for the pound

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Concurrently with the significant adjustments in the pound's value, the British equity market has also felt the impact, as evidenced by the FTSE 100 Index dropping 7.91% from September 13 to September 29.

The confusion in market expectations stems mainly from the newly-appointed Prime Minister Liz Truss and her administration's series of policy reversals, which have led to a crisis of confidence in UK government bondsFollowing Truss's ascent to power, her government set an ambitious GDP growth target of 2.5%, considerably higher than the 1.8% average growth rate seen over the past decadeThis newly minted policy resulted in dramatic market turbulence, further accelerating the pound's depreciation.

On the policy front, the proposed significant tax cuts exacerbated distrust in the government’s ability to meet its fiscal responsibilities, effectively shattering the prevailing confidence surrounding the British pension system

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By 2021, the UK government's debt surpassed 100% of GDP, making the anticipated tax cuts potentially necessitate increased borrowing to maintain normal operationsUnder the twin background of budget and trade deficits, the scale of the tax cuts raised serious rampant concerns about the government's debt repayment capabilities, as well as the stability of the poundThis crisis surrounding pensions only added fuel to the existing market volatility.

The contrasting pace of monetary policy between the UK and the US has further complicated the situation for the poundOn September 22, the Bank of England opted for a "moderate" interest rate hike of 50 basis points, falling short of the market's expectations of 75 basis pointsConversely, during the same meeting, the Federal Reserve raised its terminal rate forecast for 2023 from 3.75% to 4.63%. The hawkish tones of Federal Reserve officials further heightened market expectations for increased interest rates.

Additionally, rising prices for natural gas and oil have further weighed on the pound's exchange rate

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The recent disruption caused by the explosions on the Nord Stream gas pipeline and unexpected output reductions of 2 million barrels per day from OPEC+ starting in November, combined with heightened energy demands ahead of winter, have triggered renewed energy crises that exert pressure on the UK’s economic fundamentals and contribute to the pound's fluctuations.

In the short term, the pound, having been oversold, may find support near parity against the US dollarAs of October 16, speculative positions in GBP/USD futures options have receded to 26.13 million contracts, while non-commercial net positions rose from a five-week low of -68.09 million contracts to -39.17 million contractsIn terms of forward exchange rates, on September 23, three-month forward rates saw a drastic decrease of 10.5 basis points, dwindling further to just 2.69 basis points by September 28, dropping a total of 23.28 basis points since the announcement of the fiscal plan

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Following the Bank of England's emergency bond purchases, the three-month forward rates gradually rebounded above 20 basis pointsThis indicates that, at least in the short term, the pound may retain some support against the dollar around the parity level.

In the medium term, the progression towards recession in both European and American economies, alongside persistently high energy prices, will undoubtedly deepen the recessionary impact on the UK, negatively affecting the exchange rate of the poundIn 2021, the UK’s total imports and exports accounted for a staggering 40.48% of GDP, revealing a high degree of foreign dependency; with the Eurozone and the US together comprising 58.4% of UK exports, the significance of these major trading partners cannot be overstatedTheir recession, coupled with high energy prices, will spell more trouble for the UK economy.

The existing tensions between fiscal and monetary policy bring inherent contradictions, amplifying uncertainties that undermine market confidence and further bolster the pound's medium-term depreciation pressure

In August, the inflation rate in the UK skyrocketed to an annualized 9.9%, a historical highIn theory, this should prompt the Bank of England to implement more aggressive interest rate hikes to curb inflationHowever, the rapid expansion of the country's fiscal deficit following the pandemic, which reached £187.4 billion in 2021, poses a paradox; excessive rate hikes could exacerbate the government’s debt burden.

Under the dual pressure of sustained rate hikes and balance sheet reductions by the Bank of England, the soaring bond yields point towards short-term default risks that warrant careful scrutiny, as they may exert downward pressure on the pound's performanceBesides the Bank of England, the primary holders of UK government bonds include pension funds and foreign investors, accounting for a sizable 55.4% of total ownership