M IdeaG10 FX Strategy | EuropeBetter Call VolMorgan Stanley & Co. International plc+David S. Adams, CFAStrategist David.S.Adams@morganstanley.com +44 20 7425-3518 Wanting LowStrategist Wanting.Low@morganstanley.com +44 20 7425-6841 Morgan Stanley & Co. LLCAndrew M WatrousStrategist Andrew.Watrous@morganstanley.com +1 212 761-5287 Zoe K StraussStrategist Zoe.Strauss@morganstanley.com +1 212 761-0407 Morgan Stanley & Co. International plc+Dominic J KrummenacherStrategist Dominic.Krummenacher@morganstanley.com +44 20 7425-9781 We recommend buying 2-week EUR/GBP calls. EUR/GBP shorts appear stretched given investors' focus on carry and EUR/GBP vol seems complacently underpriced. Risks from expansionary fiscal policy at the March 6 budget keep the window narrow, though.GBP appears to be underpricing… Governor Bailey and the BoE's communiqués may not formally confirm that the cutting cycle is starting soon. But the implication of a dovish forecast revision could make this clear to the market anyway, in line with our economics team's base case for the first cut in May. ...the risk of a dovish surprise from the BoE meeting: Inflation is tracking 60bp below the BoE's forecast, and the December surprise being chiefly explained by airfares suggests a strong chance of a reversal in January. Wages are tracking well below the BoE's prior forecasts, a key precondition for beginning the cutting cycle, while very soft retail sales suggest that the consumer may be tapped out.Buy 2-week EUR/GBP calls: EUR/GBP is uniquely sensitive to rate differentials and insensitive to risk appetite. Meanwhile, implied vols for the pair are near post-Brexit lows despite the ECB and BoE meetings and important economic data. Are investors trading the wrong theme? Investors are short EUR/GBP to an elevated degree, reflecting the broader dominance of 'carry' as an FX theme and EUR/GBP's high carry/vol ratio. This creates a risk that the market may be wrong-footed in the event of a dovish BoE surprise.The window is narrow: We caution investors not to keep EUR/GBP topside expressions on for too long. Market focus post-BoE could quickly pivot away from monetary policy and back to fiscal policy. The March 6 budget could bring additional fiscal expansion, bolstering growth and rate expectations and GBP along with it.Please click here if you would like to be added to my distribution list.Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S....
