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Lombard Odier expects the pound to weaken against the euro as fiscal pressures mount and investors reassess the UK’s economic outlook.
In its latest global monthly research note, the Swiss private bank warns that deficits are widening in the UK and that the political room for fiscal consolidation is limited.
"Fiscal jitters are not only an American story," the report says. "In the UK, a widening budget deficit and large refinancing needs are raising concerns."
Lombard Odier argues that the pound's vulnerability will become clearer as gilt markets test investor appetite for UK risk and expects limited GBP/USD upside, even with a broadly weaker U.S. dollar.
"In currencies, we still expect broad-based U.S. dollar weakness, including against sterling, but see limited GBP/USD upside," the bank wrote.
"Still, we are more negative on sterling against the euro," it adds.
The call comes in the same week the British pound fell sharply in the wake of a global bond selloff that was spearheaded by declines in UK long-dated bonds.
The move sends a warning that markets are nervous as to the UK's debt outlook, which will likely be addressed with tax rises in the November 26 budget.
Fiscal and domestic growth struggles are anticipated by Lombard Odier to weigh on UK equities, despite some Bank of England easing and a weaker sterling offsetting earnings-per-share (EPS) growth.
The bank's research highlights that UK policy choices remain constrained, with governments repeatedly taking "less-than ideal policy choices every six months, that do the minimum but keep the economy in a state of uncertainty."
Analysts warn that fiscal uncertainty and the UK's reliance on incremental policy measures will keep pressure on gilts and the pound, even as UK assets appear undervalued in relative terms.
However, falling gilts mean rising gilt yields, which means they offer attractive returns to investors willing to pick them up.
For this reason, "gilts offer better value than European bonds, favouring 5–7 year maturities, and with term premium normalising, we expect that longer maturities will outperform other major sovereigns," says Lombard Odier.
In other words: even though gilts are pressured by fiscal risks, the extra yield they already offer makes them more attractive relative to Europe’s ultra-low yielding bonds.
Looking ahead, the Swiss bank forecasts euro-pound to rise to 0.89 on a 12-month timeframe, giving a pound-euro move to 1.1235.
Markets will now watch the UK’s Autumn Statement and ECB policy updates as catalysts for the euro-pound exchange rate in the months ahead.