According to the latest growth statistics, the UK only narrowly avoided entering into a technical recession at the end of last year, with 'zero' growth achieved during Q4, after a 0.3% decline in growth during Q3 in 2022.

With the strong possibility that the UK economy could fall into a recession this year, it's an obvious concern for many of our clients. We've put together a comprehensive guide on recessions, what to expect, and what we've learned from our 40 years in the business.

What is a recession?

A 'technical recession' is widely accepted as an economy that has achieved two consecutive quarters of negative growth, as measured by gross domestic product (GDP).

The shortest time a country could be considered 'in a recession' is six months, whereas there is no time limit to how long a country can remain in a recession. Some recessions are relatively short and sharp, whereas others can last for extended periods of time and have a lasting impact on the global economy.

What can we expect from the currency market if a recession does happen?

Valuing currencies is unique

Firstly, it is crucial to understand that, unlike assets such as equities, the value of currencies can only be measured by their performance against other currencies or a group of selective currencies. For example, the dollar index measures the performance of the USD against a weighted basket of major currencies, including the EUR, JPY, and GBP.

What happens if we do enter a recession?

In the case of the UK, the first thing that the Bank of England (BoE) would likely do in response to entering a recession is to lower UK interest rates in a bid to try and stimulate demand in the UK economy. The idea is to stimulate spending because lower interest rates would make the cost of borrowing for companies and investors cheaper.

In the case of currency (FX) changes, the pound would likely move in anticipation of that impending change of interest rates from the BoE, as markets price in the expected interest rate adjustment from the BoE. This would push the value of the pound down.

How would the markets react?

Aside from market participants monitoring incoming economic data, central banks will often attempt to forewarn markets during their regular speeches and market updates. They will share any impending changes to their interest rate policy in what markets often refer to as 'forward guidance’.

Forward guidance helps to limit shocks to the currency and smooth asset price changes and can be a crucial tool used by central banks in maintaining price stability.

For example, towards the end of 2022, when BoE governor Andrew Bailey suggested that the UK economy might enter into a long 'multi-quarter' recession, the pound suffered losses. The pound has since strengthened after Bailey (and the BoE) recently revised those forecasts, predicting stronger UK performance.

In the case of a recession, by the time the BoE made their first reduction in UK interest rates, the pound would have likely moved lower against other currencies in anticipation.

Lower interest rates also tend to equate to lower currencies over time, given the relative attractiveness of returns on assets when measured country by country. Therefore the pound would likely underperform, assuming that the UK was the only major economy to fall into a recession at that time – an outcome that the IMF has recently predicted for the UK this year.

What happens if the pound falls in value?

If the pound was to fall in value, then at some point, UK assets - such as property, would become far more attractive to foreign investors. This is because they could take advantage of the perceived double benefit of both lower prices from the fall in the broader (property) market, combined with a reduction in the pound's value.

As international investors then flock into the UK, the flow of those sterling purchases would help to put a floor in the deprecation of the pound and kick-start the process of the pound stabilising in international (FX) markets.

What about across the pond?

Interestingly, if the US were to fall into a recession, dragging the global economy behind it, the risk of a worldwide recession could drive the dollar higher. Investors tend to flock to the relative safety of US government treasuries at times of global uncertainty. And, given that most commodities are also priced in dollars, as commodities declined on weaker expected demand, the dollar's value would likely rise. Commodity prices and the dollar tend to move inversely.

This climate was particularly evident during the 1980s when the US went into recession, but the dollar value increased during this period.

Ultimately if the UK does enter into a recession, businesses that have prepared to weather market turbulence by using FX tools are the ones likely to feel it less. We help our clients adapt their risk management strategy to match fluctuating markets and agree guardrails for the amount of risk the client is prepared to take.

None of the information contained in this article constitutes, nor should be construed as financial advice.