UBS believes the British pound is vulnerable to shocks under the pressure of the Middle East conflict.

Investing.com - UBS strategists maintain a bearish outlook on the British pound, targeting EUR/GBP at 0.89 and GBP/USD at 1.31 by the end of Q2, citing ongoing Middle East conflicts and their impact on energy markets as key risks.

Since February 27, the pound has appreciated about 1.3% against the euro, supported by a sharp sell-off in short-term UK interest rates, exceeding the decline in euro rates. This rate repricing masks poor performance of long-term UK bonds and widespread risk aversion, which are typically associated with a weak pound.

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UBS believes that recent risks to the pound are heavily skewed to the downside. The bank’s Q1 target of EUR/GBP at 0.88 may be overly optimistic with only three weeks remaining in the quarter.

For GBP/USD, UBS sets a Q1 end target of 1.33 and a Q2 end target of 1.31, consistent with its revised EUR/USD forecast of 1.16 for both periods.

The bank cites several reasons why a sustained rally in the pound seems unlikely if conflicts persist and energy supply disruptions continue. Rising energy costs combined with high UK government bond yields pose challenges to the UK fiscal outlook, a key market concern.

Government policies aimed at mitigating consumer impacts could add further pressure.

Higher energy costs may worsen the trade balance through deteriorating terms of trade. If foreign investors become more cautious about UK bonds, the broad current account balance could also be affected.

Inflation shocks in a weakening economy may lead to demand destruction, unlike in 2021 and 2022 when demand was supported by pandemic stimulus measures and excess savings.

A softening labor market makes it difficult for wages to keep pace with inflation, squeezing real incomes and dampening consumption. As consumer spending weakens, businesses will find it harder to pass higher input costs onto customers, potentially impacting business investment.

A swift resolution of Middle East tensions and subsequent declines in oil and natural gas prices could trigger a short-term reversal in interest rates, removing recent support for the pound.

UBS’s Q2 target of EUR/GBP at 0.89 was initially based on expectations that rising domestic political risks would pressure the pound until mid-year, with these risks likely coming into focus after the May 7 local and devolution elections.

While attention has shifted to geopolitical issues, these domestic political risks remain in the background.

The bank previously expected the pound to recover in the second half as political uncertainty subsides, with a year-end EUR/GBP target of 0.85.

UBS maintains this target but notes that if conflicts persist and energy costs stay high, key components of its long-term positive outlook will be at risk. These include a healthy external balance, reduced fiscal premium, relatively low energy costs in recent years, and potential productivity gains from improved business investment.

UBS economists now expect the Bank of England to hold rates steady at the March 19 monetary policy committee meeting, in line with current market pricing. This reflects uncertainty over inflationary pressures from soaring oil and gas prices.

Inflation expectations have been a key consideration for MPC members in recent meetings, so any risks that could unanchor these expectations may warrant caution regarding further easing.

UBS economists forecast a 25 basis point rate cut in April and July, bringing the terminal rate to 3.25%, but note that evolving energy market conditions could reduce the likelihood or delay the timing of rate cuts.

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