UBS said in its latest note on Friday that sterling is likely to firm in the months ahead after settling following strong gains in June and July. The Swiss bank identified a set of factors it believes will underpin further appreciation of the pound.
Central to UBS's view is the combination of a persistent search for yield among investors and substantial short sterling positions that, in the bank's view, could be squeezed — prompting additional short-covering. The bank observed that sterling has been relatively stable since mid-July, a period when markets appeared to give new Prime Minister Andy Burnham the benefit of the doubt during a typical summer lull.
UBS listed several supporting elements for the pound, including recent firmer economic data, the gradual fading of the oil price impact, and market expectations that fiscal plans will not unsettle investors. The bank said these conditions are likely to contribute to an unwinding of still sizeable short positions in sterling.
On the yield front, UBS noted that sterling offers one of the highest yields in Europe, second only to the much less liquid Norwegian krone, and that the pound currently provides about 1.5 percentage points of yield advantage over the euro. The bank said this yield differential should help the pound generate stronger total returns.
UBS stressed it is not negative on the euro, but suggested that a lot of the favorable developments appear priced in. The bank cited market expectations for stronger growth driven by fiscal support and a likely final European Central Bank interest rate increase in September. UBS added that it expects the September move to be the last rate hike in the current tightening cycle.
On exchange rate forecasts, UBS anticipates the EUR/GBP cross to drift toward 0.84 before settling around 0.85, and set 0.85 as its new September 2027 projection. The bank also warned that a stronger-than-expected economic recovery in Europe could push the pair above 0.86, which would challenge its central forecast.
Looking ahead to the UK fiscal calendar, UBS said markets will be attentive to official statements as the November budget approaches. Members of parliament will return from their summer breaks to discuss potential fiscal packages and financing, and UBS indicated that these developments will be monitored closely by investors.
UBS singled out UK politics as the principal risk to its sterling view, noting sentiment could reverse rapidly if markets conclude that Prime Minister Burnham's initial announcements are fiscally imprudent. The bank therefore framed political developments and market perception of fiscal discipline as key uncertainties for the currency outlook.
Bottom line - UBS expects the pound to benefit from its yield advantage and from potential short-covering, but cautions that UK fiscal policy and an unexpectedly strong European recovery could alter its EUR/GBP trajectory.