Pound Sterling Forecast: Morgan Stanley "Increasingly Bearish"

- Investment bank says GBP liable to further losses
- Trade negotiations seen to be growing in influence over GBP
- Markets expect GBP volatility around EU Council meeting

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The British Pound saw some welcome stability over receny days and enters the weekend almost unchanged against the Euro and 0.90% higher against the U.S. Dollar, however analysts at Wall Street investment bank Morgan Stanley say they expect the UK currency to extend a multi-week decline against both currencies over coming days and weeks.

In a briefing to clients, analyst Sheena Shah says Brexit trade negotiations as driving expectations for a weaker currency, and that some significant volatility should be expected around a crunch EU meeting scheduled for mid-June.

The Pound has been at the whim of global markets ever since the coronavirus crisis gripped financial markets in late March, however we believe that grip on Sterling is starting to weaken as investors start paying increasing attention to the issue of Brexit trade negotiations.

"Until a Brexit deal has been reached, we expect any GBP rallies to be limited," says Shah.

Last week it was confirmed negotiators are at something of an impasse, an outcome that triggered a sharp decline in Sterling. The Pound-to-Euro exchange rate is currently quoted at 1.1175, placing it at its lowest levels since late March. The Pound-to-Dollar exchange rate is meanwhile at 1.2210 but considering the broad-based decline in the Dollar this week Sterling bulls will be disappointed that further gains weren't forthcoming.

"The UK government needs to decide if it plans to ask for an extension to the Brexit transition arrangement by the end of June. The market will become increasingly focused on this in coming weeks," says Shah. "As FX market positioning is neutral to only slightly bearish GBP, there is room for short positions to build as there is uncertainty in the coming weeks going into the mid-June EU council meeting and late June Brexit extension."

The EU and UK have one final round of negotiations to conduct ahead of a mid-June EU Council Meeting where European leaders will take stock of negotiations. The UK has until the end of June to apply for an extension to negotiations.

However, the UK has thus far been steadfast in the view that negotiations do not need to extend beyond year-end, raising the spectre that the two sides default to World Trade Organization trade settings in 2021.

"Options markets do price a premium around the EU Council meeting. Broader sentiment surveys suggest there isn't an expectation for the UK to ask for or get an extension, with a less than 20% probability," says Shah.

The Pound is understandably expected to become increasingly reactive to news flow concerning trade negotiations in June, with Shah saying they will pay particular attention to the UK government commentary in the lead-up to the June 18-19 European Council summit ahead of the scheduled June 30 deadline to request an extension to the transition period.

Should no extension be agreed, Morgan Stanley forecast the Pound to weaken versus U.S. Dollar, Euro and Norwegian Krone. GBP/USD would fall below 1.20 with next support close to 1.15, and GBP/EUR could fall to the 1.0870 area.

Morgan Stanley economists nevertheless expect the UK to ask for an extension of 1 year assigning a 40% probability to that scenario.

Should an extension be agreed, Sterling is forecast to strengthen against most peers, with the size of the rally proportionate to the expectation ahead of mid-June.

"The risk to our current bearish GBP view going into June is if Prime Minister Johnson suggests much earlier than the mid/late June deadline that he plans to ask for an extension. In that scenario, GBP should rally," says Shah.

But for Morgan Stanley it is not just anxiety over Brexit trade negotiations that have raised expectations for further Sterling underperformance:

"We are bearish on GBP due to the growth outlook, BoE policy easing and upcoming uncertainty around Brexit. GBP/USD has broken below the key 1.2270 support area, which is now opening room down to 1.20 initially from a technical perspective," says Shah.