JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM</strong><br /><br />AFTER falling to multi-month lows against both the euro and the US dollar, sterling was squeezed aggressively higher last week. The generally weak dollar allowed cable (sterling-dollar) to return to its best levels for over three weeks and against the euro, the pound only managed to win back about a fortnight&rsquo;s worth of losses.<br /><br />Sterling&rsquo;s rise was widely thought to be the market&rsquo;s reaction to price in a perceived reduction in the chances of the Bank of England extending quantitative easing (QE) at the next meeting, following comments by the Bank&rsquo;s Paul Fisher, who said that the policy was now working. However, it was the weight of short positions in the market which accounted for the aggressive nature of the sterling rise.<br /><br />While the better-than-expected UK labour market data released last week shone a better light on the dismal UK economic backdrop, this did not change the risk that growth in the third quarter is likely to be minimal. This week&rsquo;s GDP data, MPC minutes and public sector borrowing numbers all have clear potential to put an extension to QE back on the table and to put sterling firmly back into the doghouse.<br /><br />There is certainly a large amount of bad news priced into the pound, not least because of the severity of the UK&rsquo;s fiscal position. What made things much worse for the pound against the euro over the summer months was the UK economy&rsquo;s disappointing performance in the second quarter.<br /><br />To add to the pain, the performance of Germany and France over the same period was much better with both countries expanding by 0.3 per cent on the previous quarter.<br /><br /><strong>LITTLE CHANGE</strong><br />Even worse, the third quarter data that we have seen over the past few weeks appears to have brought little change to this pattern &ndash; the UK production sector looks to be slipping back into recession. This suggests that UK growth in the third quarter may not be much better than flat, while the Eurozone recovery may prove to still be on track.<br /><br />GDP growth in the final three months of the year should be better for the UK economy, but the impact of better economic data will be dampened by expectations that consumers will bring forward purchases ahead of the VAT increase from 1 January before returning to more prudent habits in the new year.<br /><br />While growth should have reappeared by next year, the UK economy will continue to face many hurdles. As the government starts to grapple with the huge budget deficit, the consumer will face fiscal spending cuts. Unemployment is set to rise for some months and disposable income will remain constrained as consumers increase savings.<br /><br /><strong>SEVERE INCREASE</strong><br />Although Germany is predicted to suffer a more severe increase in unemployment than the UK and the rise in the euro will offset the country&rsquo;s important manufacturing sector, a recent Bloomberg survey still forecasts that Germany will grow at 1.4 per cent year-on-year in 2010, compared to a more moderate 1.25 per cent annual growth rate for the UK economy.<br /><br />Sterling only stands to rise significantly against the euro when there is a relative improvement in the UK&rsquo;s economic fundamentals, which could come from three directions: firstly, better than expected growth, secondly a less bad fiscal deficit, or finally expectations that interest rates will rise at a more aggressive pace than elsewhere.<br /><br />Without improved growth, the government will find it difficult to rein in spending substantially without stoking fears of a W-shaped downturn. This could also see interest rates remaining at their current lows for even longer than seems likely at the moment. In all, such a situation is likely to lead to sterling falling even further out of favour.<br /><br />Given that the market is still positioned short of the pound, sterling will continue to be sensitive to good news going forward. This suggests further bouts of short-covering in sterling are likely. However, until it is clear that the UK economy is no longer lagging that of Germany and France, stretches of optimism in the pound are likely to prove short-lived.<br /><br />Euro-sterling should return to the 0.8500 area and perhaps beyond in 2010. That said, until there is a definite improvement in growth prospects there is still a risk that the pair could head higher.<br /><br />