[DanRath]

Sterling will be an under performer over the medium term, but the recent financial market optimism has provided support for asset markets and in turn allowed the pro-cyclical currencies, including sterling to move higher.

Traditionally, sterling would have been at the forefront of this type of currency rebound against the USD, especially given that it is the financial sector leading the equity markets high. However, it is interesting that over the past month, although sterling has moved higher against the USD, it has lagged behind the renewed move higher developed by the other pro-cyclical and commodity currencies. Hence, there appears to be a breakdown, or at least a loosening, of the traditional relationship between sterling and equity markets. This under performance is leaving sterling vulnerable on many of the crosses, suggesting there is potential for EURGBP to move higher in the near-term.

Sterling under performance appears to be a function of investor fears regarding the deterioration in the UK’s fiscal position. This was highlighted again Tuesday, with the publication of the net borrowing data for June which showed borrowing at GBP13.0bn. Although this is not quite as bad as feared, this is twice the amount of borrowing seen this time last year, and the cumulative borrowing for the first three months of the fiscal year now exceeds the total borrowing for the entire year of 2007 (before the credit crunch) by around GBP10bn.

Also the BoE is still trying to keep a lid on sterling gains. Recent comments from the MPC have expressed their preference for a weaker sterling and BoEs Bean added to those comments Tuesday, saying that he does not want to see a strong sterling recovery from current levels. Bean also suggested that the next inflation report is unlikely to show much change from the May report, suggesting that the inflation projections will still below target 2-years ahead, implying that further easing measures are required and that an exit strategy will not be needed for quite some time. Further disappointment is also likely to come from the UK GDP data on Friday. Market expectations for Q2 had perked up recently given the stabilisation in some leading indicators, but Bean has suggested that the Q2 data will almost certainly be negative. The market consensus is for a -0.3% q/q rate in Q2, and for the year-on-year rate to deteriorate further to -5.2% from -4.9% y/y in Q1.

Hence, traders expect EURGBP to push higher in the nearterm with a break above the major resistance clustered in the 0.8700/0.8730 area likely to trigger a further recovery towards the 0.9080 area. However, it must be noted that the increasing problems in the eurozone are likely to come to the fore as the year end approaches.