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Pound a Buy Against the Dollar says Morgan Stanley

© moofushi, Adobe Stock

- GBP up 1.5% this week, can go further says Morgan Stanley.

- As market eyes Brexit delay and customs union membership.

- Delay and economy to entice Bank of England from sidelines.

The Pound-to-Dollar exchange rate has risen by close to five percent this year already but Sterling still has further to run, according to strategists at Morgan Stanley, who have told clients they should bet on a further 3% increase during the coming weeks. 

Morgan Stanley's call was made days ago, before this week's showdown in Westminster over the UK's exit from the European Union, but there is still close to 400 points worth of upside left to go until the global investment bank's price target is met. 

Analysts at the American firm say the Pound will be catapulted higher this month as the market comes to realise that a long delay to the UK's exit from the EU is in the pipeline and that, ultimately, the eventual 'Brexit' will not change much about the current trade relationship. 

"We look to buy the dip in GBPUSD ahead of the Brexit votes in parliament this week," writes Hans Redeker, head of FX strategy, in a note to clients last week. "The base case of a "soft" Brexit appears to be becoming more positive as the probability that it retains customs union membership increases."

Redeker told clients to pile into bets on the Pound-to-Dollar rate when the market was at 1.2850, although the exchange rate has since risen above 1.3250. However, his initial target for the exchange rate was set at 1.3650, which is still some way above Thursday's level. 

Above: Pound-to-Dollar rate shown at hourly intervals.

Thursday's price action comes after the House of Commons voted with a majority to avoid a so-called no deal Brexit, in a non-binding motion that does not change current law, although the majority was less than that which rejected Prime Minister Theresa May's EU Withdrawal Agreement on Tuesday. 

The legal position still remains that the UK will automatically leave the EU on March 29 and default to doing business with it on World Trade Organization (WTO) terms if PM May's preferred exit plan is not ratified by parliament ahead of March 29. 

"As it stands in law, the UK is hurtling towards a hard Brexit on March 29. The rejection of a no deal Brexit by the House of Commons today will be a strong indication of the horror felt at this prospect. However, it will not change the law," says Jane Foley, a strategist at Rabobank.  

Wednesday's vote has paved the way for another ballot scheduled for Thursday evening that will give MPs the option to demand that PM May return to Brussels and ask the European Council for an extension of the Article 50 negotiating window that is currently due to come to an end on March 29.

Both the government and European Union have hinted that any extension would be a long one that likely requires UK participation in European Union parliamentary elections that are scheduled for May 2019. 

All 27 leaders of EU member states must unanimously approve any extension and there's no guarantee that there'll do it. There's also little telling what they might demand in return for granting an extension or exactly how long such a thing might be. 

However, an EU approval of an extension to the Article 50 would almost certainly send Pound Sterling higher as it would kick the Brexit can down the road and presumably, in the collective mind of the market, offer some hope that the entire Brexit push will eventually be abandoned altogether. 

Above: Pound-to-Dollar rate shown at daily intervals.

If and when an extension to the Article 50 period is agreed such a thing may well sideline the Brexit process in the mind of the market and lead investors to refocus on traditional fundamentals like the outlook for UK interest rates, which may then have become clearer. 

"The risks of a hawkish BoE remain underpriced - wage growth continues to rise in the UK while capacity pressures bite, suggesting potential inflation pressures. GBP is most highly correlated to local rates and rate differentials, suggesting that a hawkish shift should propel GBP higher," Redeker writes, to Morgan Stanley's clients.

The BoE has raised rates by 25 basis points on two occasions since the referendum in 2016, taking the Bank Rate up to 0.75%, and it's said repeatedly in recent months that elevated inflation and a robust outlook for consumer price pressures mean it'll need to keep raising rates in the coming quarters.

However, pricing in the overnight-index-swap market implies a BoE bank rate of just 0.81% for December 19, 2019, which is just 6 basis points above the current cash rate and suggests strongly that investors have only limited appetite for betting on a BoE rate hike coming this year.

Many economists say a deal facilitating an orderly exit of the UK from the EU would be enough to persuade the BoE to come off the sidelines and lift its interest rate again, although it's not clear if a simple extension of Article 50 would have the same effect, regardless of how long the extension turns out to be. 

For its part, the UK economy has continued to hold up well even in the face of an all-out homemade political crisis. The UK economy grew by 0.5% in January, which more than reverses the -0.4% decline seen back in December, when markets had been looking for only a 0.2% increase in the New Year. 

"Like the BoE, the OBR appears to have overweighted the surveys when cutting its 1Q19 forecast to 0.2% and will have missed the 0.5% m-o-m rebound in Jan-19 that leaves me tracking 0.4% q-o-q instead," says Philip Rush of Heteronomics

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