Pound-Euro Looks to Hold a Weekly Gain But Morgan Stanley Reckons It’s Going South

The British Pound is looking to score its first weekly gain against the Euro in four weeks following the defence of an important support area on the chart that coincided with the release of softer-than-expected German and Spanish inflation data.

However, gains are likely to be limited according to one Wall Street investment bank that says it holds a strategic trade that looks to benefit from a notable advance by the Euro against Sterling.

Strategists at Morgan Stanley (NYSE:MS) say they are ‘long’ on the Euro to Pound exchange rate (EUR/GBP) and are ultimately looking for the pair to break above its summer range as the Euro outperforms its British peer into year-end.

The Pound to Euro exchange rate fell sharply in the wake of the Bank of England’s September 21 decision to keep rates on hold but this week composed itself and successfully defended the support level at 1.15.

It now looks set to end the week with an advance, courtesy in part to the undershoot in German and Spanish inflation figures released Thursday that suggest there is limited likelihood the European Central Bank lifts interest rates again.

But the Pound is unlikely to maintain strength and a decisive break against the Euro looks set to emerge, if Morgan Stanley is correct.

“One of the most boring things to watch, though, has been EUR/GBP,” says analyst Matthew Hornbach at Morgan Stanley, referencing the range struck by the Pound and Euro that has meant neither has been able to strike an advantage over the other since the start of the Northern Hemisphere summer.

To be sure, the Euro-Pound has a tendency to enter long-running sideways trends and those watching the exchange rate have inevitably been questioning to which side the range will break.

Heading into July the odds looked to favour the Pound owing to Sterling’s broadbased outperformance that meant GBPEUR had entered an uptrend.

But Morgan Stanley is looking to the bottom end of the range (top end of the EURGBP range) as markets move into the busy autumn period.

“What could shake EUR/GBP out of its slumber? We think that the ‘spring’ of volatility could be decompressed by a drop in UK rates, bolstering both the pair and volatility,” says Hornbach.

“This suggests an opportunity for EUR/GBP to begin rising – and rising quickly – and this convexity would benefit both long spot positions and vol positions,” he adds.

Research by the FX strategy team finds the elevated level of UK bond yields relative to elsewhere has been a major source of support for the Pound, particularly against the Euro, owing to expectations for the Bank of England to easily outhike the likes of the European Central Bank.

Higher rate expectations were built around the UK’s exceptionally hot inflation, but UK inflation is now trending lower, as expected by Morgan Stanley’s economists, and the Bank of England has responded by halting its rate hiking cycle, which has in turn lowered future UK rate expectations.

UK bond yields and Pound Sterling have also fallen; EURGBP has rallied 1.12% in September as it put on its first monthly advance in nine. Price action suggests a bet on EURGBP upside by Morgan Stanley is on a sound footing heading into October.

“Once it becomes clear to market participants that the BoE is done hiking and the carry ‘free lunch’ is over, spot may rise and volatility may pick up,” says Hornbach.

‘Carry’ refers to the trade of borrowing in a currency where interest rates are low and investing where interest rates are high, creating a bid for the recipient market’s currency. It is a simple mechanical trade, provided volatility is relatively suppressed.

The market was surprised by the Bank’s September 21 decision to keep interest rates unchanged, while the decline in UK bond yields shows investors are not confident further rate hikes are coming.

In fact, the odds of rate cuts starting earlier in 2024 have increased, weighing on the Pound.

Morgan Stanley looks for Euro-Pound to rise to 0.93, which gives a Pound-Euro target at 1.0750.