Pound's Climb Can't Last Much Longer. By Nicholas Hastings

Sterling's strength is looking increasingly untenable.

The U.K.'s economic recovery is proving a lot more feeble than the market is anticipating and, as Standard & Poor's, the Bank for International Settlements and the Organization for Economic Cooperation and Development have warned, the country's public finances are only going from bad to worse.

At some stage, the international investment community will take heed and pull out, taking the pound down with them.

"Either plans for massive fiscal restraint or a rating downgrade are likely to refocus the market's attention on the dire fiscal situation," said the currency strategy team at Citigroup.

For the moment, the fact that the U.K. is the only triple-A rated country with a 'negative outlook' is largely being ignored.

Instead, the investment community is focusing on the green shoots of recovery - a rise in U.K. house prices here and an increase in manufacturing production there.

However, these green shoots are looking increasingly weak.

Sure, the latest purchasing managers' survey for the manufacturing industry may have shown output rising over the key 50 point level that suggests economic expansion. But the overall survey remains under 50 and its increase and the pace of improvement have slowed steadily in recent months.

"While it looks likely that we have stopped contracting, it is unlikely that we are heading for a boom," said Alan Clarke, U.K. economist with BNP Paribas in London.

Similarly, the 0.9% rise in house prices that Nationwide reported for June is unlikely to last given the low level of transactions and the likelihood that prices are still nudging lower.

The downward revision of first-quarter gross domestic product to a 2.4% contraction from -1.9% earlier has also helped to shake market confidence that all is not quite as it seems with the U.K. economy.

It is public finance, though, that could prove the final straw. As government spending mounts so too do estimates of public debt relative to GDP. This is expected to rise rapidly from an already damaging level of over 50% now.

As Prime Minister Gordon Brown struggles to boost the popularity of his discredited government ahead of elections next year, this state of affairs will only get worse as he launches another wild spending spree.

Simon Derrick, a senior currency strategist with Bank of New York Mellon in London, said fiscal concerns have yet to show up in the price action of U.K government bonds.

But, like others, he suggests that support for the pound might finally be starting to disappear, given the currency's failure to make a sustained break over $1.66 earlier this week.

Even more telling, Derrick added, is his bank's custodial data which shows accelerated outflows from sterling-denominated paper since the start of this week.

Early Thursday in Europe, the pound was down at $1.6439 by 0645 GMT from $1.6484 late Wednesday in New York, according to EBS. As a fresh wave of risk aversion hit the currency market, the euro was also swept lower, falling to $1.4119 from $1.4171 and to Y136.47 from Y136.71.

The dollar was up at Y96.66 from Y96.44 after China appeared to have denied reports that it was seeking a discussion of the dollar at the next Group of Eight leading industrial nations meeting next week.

Meanwhile, market sentiment was being hit by a larger than expected rise in Australia's trade deficit, a slide in Japanese equities as well as a report from Fitch suggesting that Russian banks may need to raise more capital. The latter appears to have undermined the euro particularly, given the exposure of euro-zone banks to the Russian economy.