Morgan Stanley updates GBP forecastsGBP/EUR peak has now passedBut GBP/USD to cross 1.20 in mid-2023Bank of England rate hikes now a negative for GBPOnly a return to growth can support the currency

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The British Pound is likely to remain under pressure against the Dollar until the middle part of 2023 show new forecasts from a major investment bank, but they also show the UK currency has already peaked against the Euro.

In a new research briefing Morgan Stanley says the prospect of further Bank of England interest rates hikes will actually weigh on the Pound, upending a long-held assumption that an acceleration in rate hikes is supportive of a currency.

In fact researchers find the only two factors that matter for the Pound at present are the UK economy's growth prospects and broader investor sentiment.

Neither of these factors are looking supportive at present, and this should remain the case over coming months says Morgan Stanley analyst Wanting Low.

Low, who is a G10 FX strategist at Morgan Stanley in London, says "a continued deterioration in the UK's growth outlook should keep GBP weak."

The call comes as the Pound nurses a 13% loss against the Dollar for 2022 but is flat against the Euro for the year.

UK inflation rose to 10.1% in July according to data out last week, prompting the market to raise expectations for the number of interest rate rises the Bank of England would likely deliver over coming months.

In the past expectations for higher Bank of England interest rates would have been met by a stronger Pound, but analysts have noted the Pound is no longer reacting to such expectations.

This is because surging inflation ultimately weighs on the economy's growth prospects and for international investors this is a concern and potential reason to avoid Sterling assets.

"Higher rates no longer translate to higher FX," says Low, adding, "hiking in a stagflationary environment is hardly something to cheer for, especially for the currency."

If anything, more rate hikes accelerate the growth slowdown, "a scenario that does not bode well for the currency," she adds.

Above: "Markets are still pricing in too much tightening in our view" - Morgan Stanley.

Morgan Stanley says only two drivers now matter for the Pound: growth expectations and the global market backdrop.

"The poor UK growth outlook should drive GBP underperformance relative to its risk-sensitive peers," says Low.

Yet a significant selloff in the Pound is also unlikely according to Morgan Stanley, a finding that should calm the nerves of those holding Sterling and looking to buy foreign exchange.

Low says 'short' positioning on Sterling by active investors and "very bearish sentiment should limit a material leg lower for GBP from here".

Morgan Stanley forecasts the Pound to Dollar exchange rate to end the year at 1.17, ahead of a recovery to 1.18 by the end of the first quarter of 2023. It is expected to cross 1.20 by the middle part of 2022. (Set your FX rate alert here).

Their Euro-Pound forecast is for 0.85, 0.86 and 0.86 in the above timeframes.

This gives a Pound to Euro forecast of 1.1765 and 1.16.

Above: "Higher front-end rate differentials did not translate to strong GBP/USD." - Morgan Stanley.

Should global market sentiment and UK economic growth prospects improve over coming months the prospects for the UK currency would however look rosier.

Pound Sterling Live notes a potential game-changer for the currency could be the policies introduced by Liz Truss, who is expected to replace Boris Johnson as UK Prime Minister in September.

Bloomberg reports Truss is preparing to fast-track an emergency spending package to help people cope with surging energy costs.

The report says Truss could announce the measures before Parliament rises on September 22 for a recess when political parties hold their annual conferences.

Truss is apparently "eager to act as soon as possible" on energy bills.

Were new policies to ease the impact on UK consumers and businesses then economic growth could turn out stronger than is currently expected.

Above: "UK growth expectations have fallen sharply and are now the lowest in G10" - Morgan Stanley.

"We suspect the new PM will be desperate to avoid a recession, especially with a general election likely less than two years away," says Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics.

Tombs expects temporary grants to help households cope with a spike in the cost of essentials to be announced by the new administration.

An emergency budget could take place as soon as September, according to media reports.

"All told, then, we expect Ms. Truss to announce extra measures in September that would boost public borrowing by about £20B in 2022/23, and by £32B in 2023/24. We judge a fiscal package of this size would keep GDP stable," says Tombs.

Stable GDP would prove to be a positive growth surprise given the low expectations currently held by the market, which is following the Bank of England's forecasts for the economy to slide into recession at year-end and stay there for the foreseeable future.

This can only be a supportive development for the Pound.

Pantheon Macroeconomics expects Pound-Dollar to end 2022 at 1.20 and end 2023 at 1.25. The Pound-Euro exchange rate is forecast to end 2022 at 1.15 and 2023 at 1.12.