Sterling is stuck in the middle of a tug of war

WITH higher rail fares, energy bills and from yesterday, VAT, 2011 is so far not looking like a very happy New Year for many British consumers. But despite the higher costs, they can at least take solace from the fact that the economy does seem to be recovering fairly remarkably. And the pound seems to be following it up. Sterling rose 0.9 per cent against the dollar and 0.5 per cent against the euro yesterday after the release of unexpectedly positive British manufacturing data.

So should traders bank on the further appreciation of sterling?

“It’s a difficult one” says David Jones, chief market strategist at IG Markets. “In three months time, I wouldn’t be surprised if we’re roughly where we are now, but in the meantime, there should be a lot of volatility”.

According to Jones, sterling is balanced rather perilously between two approximately equal forces, rather like a rope in a well matched tug of war.

At one end of the rope, a recovering economy, a declining fiscal deficit and the possibility for interest rate increases to combat inflation all ought to boost confidence in the pound. At the other end, however, ongoing fears that austerity measures will cut into the ground beneath the recovery will encourage short sellers, as will the possibility of new global crises.

Jones says that it will take “probably until the summer” until that battle is resolved – if not longer – and in the meantime, sterling is likely to see big swings as and when news comes in. Jones argues that it is probably “sensible to be on the longish side, but also ready to take profits”.

If traders do want to go long on the pound, Manoj Ladwa, senior trader at ETX Capital, reckons that the sterling-dollar pair might be a better trade than sterling- euro.

With Barack Obama’s administration facing deadlock in the now Republican controlled House of Representatives, tackling America’s fiscal deficit is unlikely to prove easy. If markets begin to believe that the Federal Reserve is simply monetising the USA’s debt then they could start selling the dollar. As a result, if the pound manages to climb above the psychologically important $1.60 level, Ladwa reckons “it could well outperform further”.

Conversely, against the euro, any rally might be weaker. Though sovereign debt fears in Europe have not disappeared, they have lessened of late. The Chinese government recently expressed its intention to buy up more Spanish sovereign debt, while the European Central Bank is providing much needed liquidity.

That, in combination with robust growth in Germany and even now in other economies, means that the euro could well push higher against the pound – even if, as is likely, the British economy also continues to recover. Traders need to make sure they are aware of the relative performance of the British economy – not just the absolute.

At the moment though, the prospects look good, and sterling will probably eventually appreciate. But with uncertainty still ubiquitous, traders might do better to try to profit from volatility. The tug of war will take a while to be won yet.