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Hard Brexit fears prompt Morgan Stanley to ditch long U.K. bet

Morgan Stanley has predicted the pound will fall another five cents against the dollar by the end of 2018, completely reversing a previous prediction in March, citing the increased risk of a 'hard Brexit' in the event of an increased majority for the governing Conservatives in June 8 elections.

"For sterling to do better, we need to see Brexit negotiations turning constructive, allowing markets to assume the British economy avoiding a cliff-edge Brexit," the U.S. investment bank's FX strategists said in their mid-year outlook on June 4.

The pound was up 0.25% against the dollar on June 5, reaching $1.292.

It last traded consistently above $1.30 in the third quarter of 2016, when market consensus was for a softer Brexit - loosely defined as the agreement of a new trade deal with the European Union within a two-year negotiation period, and perhaps a transitional arrangement to help banks and firms adapt to the new framework after the U.K. leaves the bloc.

In March, when sterling was trading in the low $1.20 area, Morgan Stanley predicted the currency would finish 2018 as high as $1.45. They now expect the pound's peak to be just $1.26 in 2018, coming in the first quarter, before a slide to $1.23 by the end of the year.

The sharp reversal is the latest example of how a tightening UK general election race is playing havoc with investors' outlooks for the U.K. economy.

A series of polls in recent days has seen what once seemed an insurmountable lead for the Conservative party over their Labour rivals cut to single figures. A YouGov projection on June 5 suggested the Conservatives would fall 21 seats short of an absolute majority.

Analysts broadly agree that a strong majority for Prime Minister Theresa May's Conservatives in the vote on June 8 would see the pound rally due to the relative certainty it would bring. But there is much less agreement over whether this could mean a softer Brexit - because May would have the strength to face down the anti-EU hardcore in her own party - or a harder Brexit, based on May's comments during the campaign that she would be happy to walk away from negotiations without a new trade deal.

Sterling shifting

Morgan Stanley is still predicting a Conservative majority, according to chief cross-asset strategist Andrew Sheets.

"We have had an election called since the March forecast," he said. "Since that initial forecast the odds of a larger Conservative majority and a harder Brexit have gone up, in our economists' thinking, and both of those are consistent with a lower pound on a 12-month view.

"Sentiment towards the pound has also shifted. Back in March sterling was one of the most favored underweights in the market, whereas that positioning has now moved to be much more neutral. We were expecting a short squeeze to help the pound, which is now less of a factor."

FX speculators cut their net short position in sterling by 61,531 contracts in May, the biggest ever monthly shift, according to data from the Commodity Futures Trading Commission.

However, bearish bets against the pound increased in the week to May 30, bucking a trend that had prevailed for the previous six weeks, according to a June 5 note from Rabobank FX strategist Jane Foley.

"Opinions polls are suggesting that the Labour opposition is gaining momentum ahead of the election," she said. "This reduces the likelihood of a strong government in the U.K. and may increase the likelihood of a more messy Brexit process."