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‘Darling’ sterling faces strong headwinds

The UK pound has steadily appreciated against leading currencies during the past year, as positive economic data have provided a much-needed boost – but Scotland’s looming referendum on independence and escalating fears of a UK housing bubble suggest the rally is reaching its final stages, predict analysts.

The days of two dollars to the pound are but a distant memory, as the pound was decimated in the aftermath of the global financial crisis.

In January 2009, cable (GBP/USD) fell to as low as 1.38 while GBP/EUR almost hit parity, and cable has mostly hovered in the mid 1.50s since, while the UK languished in recession.

However, the UK has finally emerged from recession, and positive economic data have given the currency a fresh fillip. The UK economy grew by 0.8% in the first quarter, according to statistics from the Office for National Statistics.

The National Institute of Economic and Social Research said earlier this month UK economic activity is increasing towards pre-financial crisis levels, and upgraded its 2014 growth forecast to 2.9% from 2.5%. This has benefited sterling at a time when leading currencies are largely benign.

“The UK pound has generally outperformed its peers in what is a low-volatility environment,” says Paul Chappell, founder and chief investment officer at currency management firm C-View. “Net moves in most major currencies have been relatively small since the beginning of the year.”

sterling strip

Cable is now trading at 1.68 and market participants predict it will break through 1.70 for the first time in years. GBP/EUR has steadily risen higher to the current level of 1.22.

“[Sterling has] been the darling of FX markets; the market is desperate for yield,” says Neil Mellor, currency strategist at BNY Mellon. The bank predicts cable will hit 1.70, before levelling out to 1.66 at the end of the year.

Sterling peak

Indeed, analysts predict that, while sterling has room to appreciate a little more, current valuations are starting to look stretched.

Morgan Stanley’s FX research team forecasts that this week’s retail sales figures (May 21) will be below-consensus and “it could take larger upside surprises for GBP to remain supported”.

Sterling has strengthened against the dollar partly because the US currency has failed to make a comeback this year, as widely predicted. However, analysts remain confident US economic data will improve and the dollar will strengthen, which would be negative for the UK pound.

Furthermore, there are a number of potential headwinds – Scotland’s referendum on independence from the UK is edging closer. Scotland will vote on September 18 whether to leave the UK and exist as an independent country, which analysts agree would be disastrous for the UK pound. The fear of a yes vote alone could trigger a sell-off of sterling.

“Do we really think there will be a yes vote?” asks Chappell. “Probably not, but if the polls suggest otherwise that will absolutely cause uncertainty.

“If Scotland were to vote yes, that would mean everything is up for negotiation between the rest of the UK and Scotland, which would cause some sort of a hiatus. The fear of it happening will possibly drive the pound weaker throughout the summer.”

Meanwhile, the UK housing market is concerning analysts and central-bank officials alike. Mark Carney, governor of the Bank of England (BoE), warned on Sunday the housing market has “deep, deep structural problems” and poses the biggest threat to the UK’s economic recovery.

Analysts will mull over this week’s breakdown of UK GDP figures to look for signs the UK is moving towards more investment-focused growth, as opposed to growth that is fuelled by rising house prices. This would support sterling in the longer term.

Analysts are recommending a number of short- and long-term sterling trades, including selling EUR/GBP. The European Central Bank is reportedly considering a number of options to boost inflation, while in the UK the focus is more on when the BoE will raise interest rates.

“Positive forward-looking indicators and expectations for incoming investment are likely to keep UK asset markets well supported, allowing GBP to sustain gains over the medium term,” says Morgan Stanley’s FX research team in a note published on Monday.

However, some analysts believe all good things have to come to an end and are more bearish on sterling over the longer-term. UBS’s official three-month forecast for cable is 1.60, and it is recommending clients go short sterling.

sterling fx table 1 
 sterling fx table 2
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