Sterling Looking More Like A Busted Flush. By Nicholas Hastings

Sterling is looking more and more like a busted flush.

Chances are that the currency will soon be back down at $1.58.

For the moment, the pound continues to display some resilience but its bounces are becoming weaker and underlying support is slowly ebbing away.

Not only is the U.K. economic recovery proving weaker than expected but the country's fiscal deficit is even more a burden than forecasters had feared - putting Britain at the top of the list of triple-A credit countries under threat of a debt downgrade.

Hans Redeker, head of global foreign exchange strategy at BNP Paribas in London, summed up the change in mood: "Let's face it, sterling has lost its long-term attraction as a stable investment currency."

Optimism that the U.K. economy was pulling itself out of recession has just about run out. The green shoots in the housing market have turned yellow. Any improvement in retail sales has been driven by price cuts. And now, the rise in industrial production that had started to emerge has proved to be a flash in the pan. After May's 0.2% rise in production, a similar increase was expected for June. Instead, it fell 0.6%, increasing the risk that U.K. Inc. is heading back into recession.

Even before these numbers were released Tuesday, market participants were starting to bet that the Bank of England would increase its quantitative easing program by another GBP25 billion to a total of GBP150 billion when it completes its next policy meeting Thursday.

Some forecasters suggest that the central bank may have to expand its program as far as GBP200 billion before the country is back on its feet.

This in itself is quite damaging enough for sterling. As the prospects for a global recovery diminish, the pullback in investor risk appetite will certainly ensure that the pound suffers.

However, it is the fiscal fallout that is likely to cause the most lasting damage to the British currency.

Even before the latest rash of disappointing data, the country was set to run up a deficit of over 11% of GDP this year.

Now, chances are that growth projections will be scaled back at a time when the government is facing heavy union resistance to its attempt to curb costs - a combination that will only send the deficit even higher.

With the public sector in the U.K. representing over 50% of the economy, and its productivity proving markedly lower than the private sector, this poses a major problem.

"The bigger the state sector becomes, the lower the productivity and final trend growth potential will be," warned BNP Paribas' Redeker.

For the time being, though, sterling is still attracting a certain level of support, with the latest GBP4 billion 10-year auction Tuesday getting nearly twice the number of bids that were needed.

A further rise in risk aversion early Wednesday, however, left the pound on the decline once again. By 0713 GMT, it had fallen to $1.6116 from $1.6128 from late Tuesday in New York, according to EBS.

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A sharp fall in Japanese core machinery orders, rising concern about the unrest in China that's prevented President Hu from attending the G8 summit in Italy, another sharp decline in crude oil prices and tumbling stock markets have all contributed to the rise in risk aversion.

The dollar has fallen to Y94.35 from Y94.82, while the euro has declined to $1.3907 from $1.3912 and to Y131.16 from Y131.91.