IF YOU ever wanted to see a classic example of a short squeeze you simply need to look at the recent chart of sterling-dollar. Less than 10 days ago, currency traders could not give away the pair fast enough in the aftermath of the disastrous fourth quarter UK GDP figures, which contracted by -0.5 per cent versus forecasts of 0.4 per cent rise. But then just a day later unexpectedly tough Bank of England (BoE) minutes suddenly changed the market’s mind as a new member Martin Weale joined the perennial hawk, Andrew Sentance, in voting for a 25 basis point rate hike.

Yesterday the think tank the National Institute of Economic and Social Research came out with a report stating that the BoE will need to raise rates at least three times this year in order to tame inflation which has been running well above the 2 per cent target level for more than year. That news along with a record high reading in the latest purchasing managers’ index (PMI) sent sterling soaring to a fresh yearly high of £1.6140.

Despite the widespread optimism, I remain sceptical that the pound can climb much above the £1.6200 level given the current state of affairs. Manufacturing has indeed been the lynchpin of the UK economic recovery and yesterday’s data confirmed that it remains the best performing sector of the UK economy. But manufacturing makes up only 13 per cent of the UK GDP and therefore will have limited impact on overall growth. Meanwhile the service sector continues to suffer from lacklustre retail demand and a weak housing market.

Therefore this Thursday’s UK PMI services report may be the make or break data point for the pound this week. Markets are anticipating a rise back above the 50 boom/bust level to 51.1. If PMI services does surprise to the upside, the pair could extend its rally to £1.6200 and beyond. However, if the data misses, as I suspect it will, cable could finally head toward ground as reality sinks in. Currently, the forward market is pricing in at least two rate hikes before the end of the year. I believe that is wildly optimistic and rates will likely remain at 50 basis points for the rest of 2011.