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UBS says the British Pound could decline to $1.35 by year-end.  In a recent strategy note they listed 7 reasons why the Pound could decline for the remainder of the year:

1)  the pound has rallied because Bank of England Monetary Policy Committee member Andrew Sentance voted to raise interest rates. But the rest of the MPC seems unlikely to join him.

2)  the pound has also rallied recently because of the new government’s Budget announcement.

3)  the scale of budget cuts envisaged over the next four years – on average the UK fiscal deficit will be reduced by 2% of GDP each year – presents risks to growth.

4)  exports can’t be relied upon to take up the slack. Britain’s main trading partner is the Eurozone, not resilient emerging markets. Despite sterling’s weakness over the last two years, the UK trade balance has not improved significantly as the Eurozone has also weakened.

5)  the MPC remains willing to resume quantitative easing if the economy weakens. Though the BOE stopped purchasing Gilts in February, its policy setting committee has stressed that quantitative easing has been paused rather than being terminated. Thus if fiscal tightening later in the year does cause economic growth to falter, the MPC is likely to respond with more Gilt purchases if it feels it will miss its inflation target in two year’s time.

6)  tighter fiscal and looser monetary policies can result in a much weaker pound as sterling’s performance after the 1981 austerity budget shows. In the early 1980s the pound fell for several years against the dollar and the German mark after the UK government cut the budget deficit and the Bank of England responded by cutting interest rates from 14% to 12%.

7)  other major currencies have also experienced similar prolonged weakness when the authorities have tightened fiscal policy and loosened monetary policy during times of economic weakness.

How to play it?  UBS likes put spreads on the Pound and straight short positions:

“Sterling is likely to weaken substantially in the second half of the year. We already recommended buying two month GBPCHF put spreads with 1.6300/1.5425 strikes on June 10. We now also recommend clients add to sterling shorts by selling spot GBPUSD at 1.4975 with a stop above the recent highs at 1.5270 and an initial target of 1.4000.”

Source: UBS

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