A drop in stocks and a rise in QE will undermine sterling's rally

IN THE face of a ballooning fiscal deficit, quantitative easing and the deepest recession since the Second World War, sterling rose to a nine-month high against the dollar of $1.7005 in Asian trading yesterday morning. And against the euro, it is just shy of the June highs of &euro;0.8426. It&rsquo;s hard to believe that as late as February, pre-eminent investors such as Jim Rogers were touting the possibility that the pound would reach parity with both the dollar and the euro &ndash; and that the latter was nearly reached. <br /><br />Granted, the pound&rsquo;s rise to these extraordinary levels has been fuelled by three factors: firstly, sterling was by all accounts oversold at the beginning of 2009 and was therefore due a correction, secondly, the return of risk appetite to the markets in conjunction with an astounding &ndash; and perhaps now overcooked &ndash; equity rally and thirdly, the perception that the Eurozone has been the laggard in terms of monetary intervention.<br /><br />This has prompted some foreign exchange analysts to forecast a further rise in sterling ahead, boosted by dollar weakness and a recovery in the UK economy. Investment bank Calyon is targeting $1.75 in cable by the end of 2009 and $1.90 by the end of 2010.<br /><br />But whether sterling makes it as high as these optimistic levels will depend on two factors, neither of which is looking particularly guaranteed right now.<br /><br />Firstly, the UK&rsquo;s own economic recovery is still fragile and far from assured. Admittedly, recent UK economic data such as the manufacturing purchasing managers&rsquo; index and housing market figures has been better than expected, which has contributed to the sharp jump in sterling over the past few days. But the general consensus is that any recovery will be slow and painful and any rise in sterling will choke off the gains made by the manufacturing sector. <br /><br /><strong>KICKSTART LENDING</strong><br />Meanwhile, a large question mark hangs over Britain&rsquo;s further use of quantitative easing (QE) to stimulate the economy and kickstart lending. Further clarity is expected at this week&rsquo;s Monetary Policy Committee (MPC) decision this Thursday but the uncertainty and &ldquo;the continued risk that the Bank of England could yet extend QE, which could make further near-term gains difficult,&rdquo; says Jane Foley, research director at Forex.com.<br /><br />Nick Beecroft, senior foreign exchange consultant at Saxo Bank, says: &ldquo;On balance the MPC probably will extend QE but not raise it beyond &pound;150bn. But the market is split so it could be a volatile day and also a sterling-negative day.&rdquo; Beecroft adds: &ldquo;Now might be a good level to sell cable on a six-month view: it&rsquo;s looking a bit toppy. Sterling doesn&rsquo;t have much upside against the euro either &ndash; I see an &euro;0.84-&euro;0.87 range in euro-sterling.&rdquo;<br /><br />Secondly, a rise in cable will equally need dollar weakness. Given the tight inverse correlation between the US dollar and the S&amp;P 500 stock index, cable&rsquo;s rise has been strong because of the Dow&rsquo;s rally, says Boris Schlossberg in the opposite column. And sterling will need stocks to continue rallying and the US economic data to continue recovering. <br /><br /><strong>HIGHER-YIELDING ASSETS</strong><br />But the recent positive news has made the dollar less attractive because investors are taking money out of the US &ndash; which they still perceive to be a safe-haven &ndash; and seeking higher-yielding assets elsewhere. Should we see the equity rally run out of steam &ndash; many equity strategists believe it is based on pure optimism rather than the fundamentals &ndash; then we could see investors returning their assets to the US dollar and US Treasuries, which would be beneficial for the dollar at the expense of the pound. <br /><br />With this in mind, foreign exchange traders with long positions in cable&nbsp; should avoid being too greedy and sitting in their positions hoping to eke out another few basis points of profit. <br /><br /><strong>FEELING BOLSHY</strong><br />Christina Weisz, sales director at Currency Solutions, says: &ldquo;I think that sterling has reached key levels against the dollar and the euro. The problem is that we&rsquo;re at nine-month highs and it&rsquo;s very easy for it to nip back down.&rdquo;<br /><br />&ldquo;I think the prudent clients will look to act now and crystallise their profits, but if you&rsquo;re feeling a bit bolshy then hold out for a psychological level but don&rsquo;t get too greedy. I don&rsquo;t think we&rsquo;ll get above $1.72,&rdquo; she adds.<br /><br />John Rivera, currency strategist at FXCM, thinks it might go even higher. &ldquo;The crowd is starting to jump on the sterling bandwagon, which could see sterling-dollar look to test 1.7332 &ndash; the 50 per cent Fibonacci ratio of 2.1168-1.3503 &ndash; but could see a sharp reversal thereafter.&rdquo;<br /><br />The problems that brought sterling to the lows of January-March have not gone away, they have only been tempered by better economic news and market optimism. Should the MPC extend QE, as many believe it should, and the equity rally fizzle out, as again many believe it will, then sterling&rsquo;s day in the sun will cloud over. Lock in your profits, while you still can.