DJ Forex Focus

Sterling's rally against the dollar will not last much longer.

The currency's gains have been built largely on inflated hopes for the U.K. economy that will soon be proved wrong.

And cable, which has already shown signs of struggling this month, will fall.

The pound's rally, which has taken it up to nearly $1.6600 now from about $1.3750 in early March, came as data showed signs of an economic rebound.

House prices have stabilized in some areas, consumer sentiment has improved and some forecasters have suggested that positive GDP growth could reappear as early as the third quarter of this year.

Currency players have continued betting on the pound in recent weeks even though global risk appetite has stopped improving, equity markets have faced a shake-out and the pound's traditional correlation with financial stocks appears to have broken down.

The fact that merger and acquisition flows have turned very much in Britain's favor and that some analysts consider the currency to be still undervalued against many other majors has only contributed to upward pressure, ensuring that sterling has outperformed most of its competitors.

But, the time of reckoning for the U.K. currency is close.

First, as robust as the U.K. recovery may now appear, this upturn has been fueled entirely by the GBP25 billion - or 1.6% of GDP - that the government has poured into the economy since the credit crunch started.

Once this fuel runs out, so does the economic stimulus. With the government's deficit already up at about 12% of GDP, there is certainly no room for more government action on that scale.

Hans Redeker, head of global foreign exchange strategy at BNP Paribas in London, summed it up: "The eventual removal of this fiscal stimulus, likely after the general election next year, will leave the growth outlook in a far more precarious position."

If anything, Redeker warned that far from being an overperformer now, the U.K. economy could become an underperformer in the medium term.

There are already indications that the rebound in the housing market may not last as negative equity continues to rise and that retail sales may not be quite as strong as initial data suggested.

The Bank of England itself has been at the forefront, warning not only that the recovery will be "protracted" but that the recent rise in sterling will only make matters worse.

Earlier this week, the bank's chief economist Spencer Dale made it pretty clear that a weaker pound would be more helpful. Without it, British industry will remain under pressure and a rebalancing of the economy will prove even more difficult as the country's export sector suffers.

For now, a weak dollar and continued optimism about the U.K. could keep the pound bouncing around near its recent highs. But, once the market reassesses the country's economic future, and once risk aversion returns, putting upward pressure on the dollar, the pound will more than likely find itself retracing the gains it made in recent months.

Early Thursday, the pound was rising along with other high yielders after a benign statement from the FOMC late Wednesday lifted risk appetite.

By 0710 GMT, it was up at $1.6379 from $1.6385 late on Wednesday in New York.

The dollar was up at Y96.40 from Y95.68 while the euro rose to $1.3962 from $1.3901. The single currency was also up at Y134.75 from Y132.99.


Bloomberg TNI FRX POV

Reuters USD/DJ
Thomson P/1066 or P/1074
(Nick Hastings has covered the foreign exchange markets and industry for over 15 years. Apart from his written commentary and analysis, he also appears on CNBC television in Europe, Asia and the U.S. He can be contacted on +44-20-7842-9493 or by email: nick.hastings@dowjones.com)