Sterling Support Will Swiftly Crumble. By Nicholas Hastings

Watching sterling rally is like watching a piece of elastic being stretched.

Before long there will be a nasty snap back.

The latest gains in the pound have been driven not only by short-covering and technical positioning but also by optimism over the Bank of England's decision to increase its quantitative easing last week by only GBP25 billion rather than the GBP50 billion that many had feared.

Given the current strength of market momentum, and a continued base appetite among global investors for risk, the pound could yet make it through resistance at $1.6693 and $1.6871 to head back to its high for 2009 to date of $1.7041.



Once there, however, support should swiftly crumble.

The reasons for the Bank of England's decision to limit the increase in QE - economic recovery and a rise in inflation - are already starting to look highly suspect.

Since the bank's decision was announced last Thursday, a new report by the National Institute of Economic and Social Research has wiped out any hopes for an early economic upturn. The institute estimated that the economy contracted by another 0.4% in the three months to the end of October, instead of remaining flat as initially hoped.

New producer price data on Friday, showing a rise in year-on-year input prices for the first time since last February, may have justified the central bank's cautious move on the surface.

However, the rise has been largely due to base energy effects and input price inflation will prove short-lived.

"It would be wrong to worry about a sustained rise in cost pressures in the economy," said Jonathan Loynes, chief European economist with Capital Economics in London.

In other words, chances are that the Bank of England may yet have to increase its QE once again, especially if the U.K. economy doesn't produce the bounce the central bank has so long been looking for.

For the pound this will hardly be good news, especially given that some countries such as Sweden have suggested they will start to withdraw, not extend, their emergency monetary measures, and the European Central Bank hinted last week that it could start exiting its strategy as early as next year.

While the timing and speed of the pound's reversal against the dollar may also be subject to the strength - or otherwise - of the U.S. currency itself, sterling could well find itself under pressure against the euro as the policy directions of the Bank of England and the ECB continue to diverge.

Combine this with the continued fiscal deterioration that is taking place as the government throws more money at the banking system and the rising prospect of serious fiscal tightening next year and it is only a matter of time before support for the pound runs out.

The pound was heading higher again early Monday in Europe as the failure of G20 finance ministers to mention currencies in their weekend communique after a summit meeting in Scotland helped to lift sentiment. Suggestions that the U.K. and U.S. won't be rushing into early monetary tightening also contributed to the improved mood, with investors seeking higher-risk assets.

By 0745 GMT, the pound had risen to $1.6664 from $1.66608 late Friday in New York, according to EBS.

The dollar was up at Y90.23 from Y89.96, while the euro rose to $1.4956 from $1.4844 and to Y134.99 from Y133.53.