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Foreign exchange strategists at NatWest Markets have exited a long running trade recommendation that looked to benefit from the British Pound's appreciation against the Euro and Franc.

The UK based lender and investment bank has held a recommendation for Sterling-Euro upside since early 2021, eyeing an economic recovery driven largely by fading Brexit premiums and the country's rapid vaccine rollout.

But the UK's economic outlook faces significant challenges as the second quarter approaches amidst surging global and domestic inflation, boosted since late February by Russia's invasion of Ukraine.

"It’s possible softening growth prospects soon start to outweigh tighter monetary policy," says Paul Robson, Head of G10 FX Strategy at NatWest, signalling a potential shift in Sterling's drivers.

For 2022 the long-Sterling theme was extended by the strategy team, but this time against the safe haven Swiss Franc which has been an unsurprising beneficiary of the war in Eastern Europe.

The Pound nevertheless started 2022 on a firm footing and NatWest's winning trade looked to deliver further gains, rallying against all major peers as investors bet the Bank of England would lead central bank peers in raising interest rates.

But fast-forward to March and this channel of support appears to have lost potency; indeed the Pound is now the worst performing major currency of 2022.

Above: GBP/EUR has delivered significant upside since 2021, but could the rally have reached its zenith?

Reference rates at publication:

GBP to EUR: 1.1879High street bank rates (indicative): 1.1462 - 1.1545Payment specialist rates (indicative): 1.1770 - 1.1810Find out more about specialist rates and service, hereSet up an exchange rate alert, hereThe war in Ukraine which has pended the positive narrative on Sterling, pushing commodity prices notably higher and increasing inflationary headwinds.

Economists calculate surging inflation will compromise consumer sentiment and spending power to the degree the economy underperforms relative to expectations held at the start of the year.

"While monetary policy developments will remain an important driver of the currency, portfolio rebalancing and risk appetite that’s influenced by Ukraine are also likely to be important in driving sentiment," says Robson.

The Pound has traditionally traded as a pro-cyclical currency that appreciates during times of economic expansion and bullish investor confidence, but it struggles during times of intense market anxiety.

Indeed the Pound's lowest values reached against the Euro came in the wake of the 2008 financial crisis and then again during the Coronavirus market selloff of early 2020.

Market anxieties and a downgraded economic growth outlook linked to Ukraine are therefore inevitably providing an uncomfortable context for Sterling bulls.

"Given growing uncertainty over the UK growth outlook, we have decided to close our long Sterling against EUR and CHF position," says Robson.

Looking ahead, Robson says the Pound could become more attractive as a strategic 'long' were the UK government to offer the economy support.

"A large fiscal response to offset the cost of living shock would add new vigour to currency’s rise against the EUR, so the upcoming Budget on March 23rd has taken on greater significance for the currency," says Robson.

As it stands the government looks unwilling to provide significant support and will proceed to raise National Insurance requirements on employers and employees in April, the same month consumers are hit by a lift in the energy price cap.

The Pound to Euro exchange rate is at 1.1881 at the time of writing, having started 2022 at 1.1898 and having been as high as 1.2190.