This currency pair offered the most opportunities for profit in 2022

Beginning of 2022 - the calm before the storm

The beginning of the year may not have been anything special - you could buy around $1.35 for one pound, which was rather above average in the long run. And while many of you might have expected a slight weakening of the pound, no one could have prepared for the shock in the form of the Russian invasion of Ukraine. Inflation rocketed and central banks around the world were forced to start tightening monetary policies. Some more boldly than others.

We must also not forget that the world had just recovered from a coronavirus pandemic, during which enormous liquidity was being released as part of aid packages to the people. It is here that the second cause of the rapid rise in inflation can be seen. Moreover, Britain was still reeling from Brexit. Although the British pound was relatively strong compared to the US dollar, the UK was certainly not prepared for the impending shock.
 

_{Long-term trend of the GBP/USD currency pair in the MT4 platform}

Interest rates on the pound - starring: the Bank of England

The Bank of England, like its European counterparts, has long maintained a policy of extremely low-interest rates. The Bank of England's first cosmetic rate hike came as early as the end of 2021. However, huge inflation is also crushing the UK, and the central bank has had to gradually resort to bigger and bigger hikes. These seem to have culminated in a 75bps hike in November. In fact, inflation climbed to its highest level in more than 40 years in October, breaking 11%. The path of the UK base rate is shown in the chart below.
 

_{Bank of England base rate}

Interest rates on the dollar and a bold Fed

The US Federal Reserve was considerably bolder, raising the key interest rate gradually up to the 3.75%-4.00% range (as of 12/12). The higher rates made the US dollar more attractive, and it began to strengthen virtually across all currency pairs, and the pair with the pound was certainly no exception. Moreover, all indications are that the Fed will continue to tighten monetary policy. However, the data from the economy - especially inflation and the labor market - will matter significantly. The latter is still looking overheated, with unemployment at 3.7%, one of the lowest on record. The strong labor market is hampering the central bank's efforts to fight inflation. The evolution of the US base rate is shown in the chart below.
 

_{Fed funds rate}

September 2022: The pound plunge that made history

The aforementioned interest rate adjustments and the USD's reputation as a safe haven probably would not have been enough on their own to produce the historic GBP/USD plunge we have witnessed. The currency pair has been on a downward trend since the beginning of the year and reached an extreme towards the end of September. The GBP/USD pair fell to an all-time low when its exchange rate dropped below the 1.04 level and the market had already started to look impatiently for the parity line.

But what caused such chaos in the UK? This question is an easy one to tackle - it was political instability. Specifically the state of affairs that the then-new Prime Minister Liz Truss and Chancellor of the Exchequer Kwarteng sent Britain into. The Prime Minister first promised to cap energy prices for the average British household at £2,500 a year, which was to cost the Treasury between £70 billion and £140 billion.

However, the Chancellor's package of measures to cut the tax rate for corporations and the very wealthiest citizens, and several other measures to give relief to the British people, literally came as a shock. However, these measures had a large inflationary effect and undermined the central bank's efforts to fight inflation. The package was thus met with huge criticism from the opposition (understandably) but also from the IMF and the US President. The pound, which has fallen to almost an all-time low, and government bonds, whose yields have risen significantly, have all paid the price. So Minister Kwarteng was dismissed and replaced by Jeremy Hunt. However, the Prime Minister did not stop the situation and had to resign for a record 45 days. Thus, Britain practically went through an economic collapse and the central bank had to step in again to save the day by buying government bonds.
 

_{Expected decline of the GBP/USD pair. Source: cTrader}

We were expecting a slight correction and then a return to the downtrend. We identified the 1.07 level as the expected level of strong support. However, even we had no idea how huge the fall in GBP/USD would be at the end of September. 

What to expect from EURUSD in 2023?

With the cancellation of the planned tax packages, a new Prime Minister, and Chancellor of the Exchequer, the UK economy has stabilized again and even with the gradual weakening of the US Dollar, the GBP/USD exchange rate has gradually risen to the current 1.22.

Inflation-related data is one such example. November's should be more positive in the UK, as in the Eurozone, but the UK may also suffer significantly from further rises in energy prices in Europe and instability in general. With inflation still expected to be over 6% by the end of next year, the Bank of England still has more than enough reason to tighten monetary policy further. The BoE is expected to hike by 50bp to 3.5% at its next meeting. Interest rates should then peak during the first quarter of 2023. The level of the terminal rate should be around 4.25%.

Further monetary policy developments in the US, as in the UK, will depend on inflation data for November. However, the global fall in oil prices could reflect well in these data and inflation could again turn positive in the US. It would be the second consecutive year of this and could be a signal that US inflation has passed its peak. Statements by central bank officials in recent weeks make it clear that the Fed wants to assess the impact of previous hikes on the economy and not tighten rates too much.

However, some officials still warn that the risk of inflation "taking root" is higher than the excessive raising of interest rates. The still relatively overheated labor market also argues for further interest rate hikes. Unemployment in the US is still at 3.7%, one of the lowest figures on record. To successfully fight inflation, unemployment will have to rise further. At the next Fed meeting, the market expects a 50 basis point rate hike with a probability of over 75%. The terminal interest rate in the US should then be in the range of 4.75% to 5%.