UBS strategists continue to flag the British pound as vulnerable amid heightened geopolitical tensions and the prospect of sustained disruption to energy markets. The bank reiterated a target of EUR/GBP 0.89 by the end of the second quarter and set GBP/USD at 1.31 for the same timeframe, arguing that the balance of risks is skewed to the downside for sterling if the Middle East conflict persists.
Since February 27 the pound has actually strengthened by about 1.3% against the euro, a move UBS notes has been driven by a pronounced sell-off in front-end UK interest rates that has outpaced comparable moves in euro area rates. That front-end repricing has provided a near-term lift to the currency, the strategists say, and has masked other developments that typically weigh on sterling such as the underperformance of long-dated gilts and a broader risk-off backdrop.
Still, UBS warns that the recent support may be fragile. The bank assesses its first-quarter EUR/GBP target of 0.88 as potentially ambitious with only three weeks left in the quarter, while for GBP/USD it looks for 1.33 at the end of the first quarter and 1.31 by the end of the second, forecasts the bank says sit alongside its EUR/USD outlook of 1.16 for both periods.
Why UBS views sterling as exposed
UBS sets out a series of interconnected channels through which a drawn-out conflict and elevated energy prices could sap sterling's strength:
- A negative growth shock driven by higher energy costs combined with elevated gilt yields could strain the UK fiscal outlook, a central concern for market participants.
- Policy measures aimed at protecting consumers from higher energy bills - while politically and socially motivated - could add further pressure to the public finances.
- Higher energy costs would likely worsen the trade position via a terms-of-trade shock, and the broader basic balance could deteriorate if overseas appetite for gilts weakens.
- An inflationary shock landing on an already weak economy would likely produce demand destruction, in contrast to 2021 and 2022 when demand was supported by pandemic-related stimulus and accumulated savings.
- Labour market loosening would make it harder for nominal wage gains to keep pace with inflation, eroding real incomes and weighing on consumption.
- Weaker consumer demand would feed through to business investment, as companies find it more difficult to defend profit margins by passing on higher input costs.
The combination of these forces, UBS argues, would create an environment in which sterling’s outperformance is difficult to sustain unless geopolitical pressures ease and energy prices fall back materially.
Paths to a reversal
UBS notes that a rapid de-escalation in the Middle East, with a consequent correction lower in oil and gas prices, could prompt a reversal in front-end rates moves. Such a reversal would remove a key element of recent support for the pound and could accelerate downside pressure on EUR/GBP and GBP/USD.
The bank’s second-quarter EUR/GBP target was initially based on the view that sterling would face domestic political pressure through mid-year, with that risk likely to return to markets’ attention after the May 7 local council and devolved parliament elections. While geopolitics currently dominates the headlines, UBS stresses that those domestic political risks have not gone away.
UBS retains a longer-run constructive target for sterling of EUR/GBP 0.85 at year-end, which it had expected to materialize as political uncertainty fades in the second half of the year. However, the bank cautions that several underpinnings of that more optimistic outlook are now at risk if the conflict persists and energy costs stay elevated. These underpinnings include a benign balance of payments backdrop, a reduced fiscal premium, historically lower energy costs and a rebound in business investment that could support productivity.
Monetary policy and rate-path expectations
On policy, UBS economists expect the Bank of England to pause at the Monetary Policy Committee meeting on March 19, leaving rates unchanged in line with prevailing market pricing. The firm cites uncertainty about the inflationary implications of higher oil and gas prices as a central reason for the anticipated caution.
UBS currently projects 25 basis point cuts in April and July, taking the terminal rate to 3.25%, but explicitly notes there is a clear risk that cuts could be fewer or delayed depending on how energy markets evolve. The strategists highlight that inflation expectations have been a focal point for MPC members at recent meetings and that any signs of de-anchoring would likely prompt a more cautious approach to policy easing.
Bottom line
UBS’s baseline over the near term is a weaker sterling if geopolitical tensions and energy prices remain elevated. Temporary support from front-end rate repricing has helped the pound recently, but the bank stresses that a prolonged energy shock, higher gilt yields and fiscal pressures would likely reverse that support and put the currency under sustained downward pressure.