TREAT RALLY IN THE POUND WITH CARE

DIRECTOR OF CURRENCY RESEARCH, GFT

TO THE surprise of many market analysts, including yours truly, sterling has been on a tear lately. Not only has the pound rallied, but it has significantly outperformed the euro, gaining more than 200 pips on the continental currency over the past several weeks.

So why such sudden explosive strength in the currency? Part of the reason for the pound’s recent gains has to do with the rebound in global capital markets in July. The better-than-expected corporate earnings in Europe and US soothed investors’ concerns about an imminent global economic slowdown, reviving risk appetite with cable benefiting from speculative flows.

However, cable has also been boosted by positive investor response to David Cameron’s economic policies, which seek to curtail fiscal spending, reduce the UK government deficit and strengthen the country’s credit rating. Cameron has argued that fiscal austerity and economic growth are not incompatible. So far, his plan appears to be working: UK economic data has been remarkably resilient with the latest UK PMI manufacturing data registering above 57 for the fifth month in a row. Goldman Sachs has stated that the UK is likely to outperform both the US and European economies in 2011.

Yet I remain sceptical that UK economic growth can maintain this pace going into the second half of the year. Cameron’s fiscal cuts have yet to hit the economy, and when they do, the impact on aggregate demand could be much more severe than the market believes. In the meantime, the so-called second derivative UK economic indicators are beginning to show that deceleration is in trend. For example, the pace of improvement in UK labour markets has declined from a reduction of 40,000 in the claimant count in February to only 20,000 in July, while the Rics house price index has fallen to 9 per cent after peaking at 21 per cent in May. In short, even if the pound rallies in the near-term, it may face a much more difficult path ahead and $1.6000 could signal a near-term top if economic reality cannot keep up with investor expectations.

Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read commentary at www.GFTUK.com/commentary or e-mail borisandkathy@gftuk.com.