Sterling Has Had Its Run For Now. By Nicholas Hastings

Optimists shouldn't be fooled by sterling's bounce.

Yes, U.K. house prices have been looking better.

And yes, the U.K. service sector is bouncing back even faster than economists had predicted.

As a result, the pound has recovered a little from its recent sharp decline below $1.58 in late September from nearly $1.70 in early August.

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But, that doesn't mean the longer-term decline in the U.K. currency is over.

In fact, economists are fairly dismissive of the positive economic news.

Take house prices. The latest house price index from Nationwide suggests that prices are back up to levels seen 12 months ago.

However, this rally has been driven largely by a lack of supply, a trend that has already started to reverse as the recession continues to bite, unemployment increases further and more households are forced to sell.

Forecasters are already working on the assumption that prices will be falling back again by 2010.

"There is the clear risk that the recent upturn in house prices starts to reverse, which could provide renewed downtrend pressure on confidence and therefore spending," warned James Knightley, senior U.K. economist with ING Financial Markets in London.

Knightley said that while he isn't looking for a further 20% decline in house prices as some economists have predicted, the trend "again highlights the risk that the overall recovery in the economy will be somewhat bumpy."

Monday's news that the latest purchasing managers' index for the service industry soared well above expectations last month also failed to have a serious impact on sentiment.

The numbers, which showed services expanding at their fastest pace in two years, certainly helped to offset last week's weak PMI for manufacturers.

But, they aren't expected to last.

"We remain skeptical that this 'trend' rate of expansion will be sustained (or even achieved in the near term)," said Vicky Redwood, U.K. economist with Capital Economics in London.

There are certainly clear signs that global investors remain very wary of the U.K. recovery.

The latest data from the Chicago Mercantile Exchange shows that speculators have been raising their net short sterling positions sharply. By last Tuesday, they were up at extremes last seen in September 2008.

Reserve managers also seemed to be having second thoughts about the pound. According to Michael Hart, an economist with Citigroup, new data shows that sterling-denominated reserves held by central banks around the world have continued to decline - taking them down by GBP7 billion since 2003.

"While the absolute decline may not appear large, this is significant given that large sterling purchases have played a big role in financing the fiscal deficit in recent years," Hart said.

And that brings us to the other key reason why investors are likely to remain shy of sterling in weeks to come - the country's massive fiscal deficit and the lack of any coherent government policy for reducing it in the near future.

Early Tuesday in Europe, the pound was up at $1.5975 by 0645 GMT from $1.5942 late Monday in New York, according to EBS.

The dollar was being knocked lower across the board by a story in The Independent newspaper that Gulf States have been holding secret talks about not using the U.S. currency for oil trading. The Saudi central bank has denied the report, describing it as "absolutely incorrect."

A rise in appetite for riskier assets after strong U.S. data Monday and the Reserve Bank of Australia's decision to hike rates for the first time since the credit crunch Tuesday has also contributed to downward pressure on the dollar.

The dollar is now at Y89.28 from Y89.54, while the euro has risen to $1.4711 from $1.4651.