Sterling's Summer Rally Built on Weak Foundations

Sterling's recent rally against the euro has been driven more by positioning and carry rather than a lasting improvement in UK fundamentals, according to analysts at ING. The pair has risen about 2% over the last month but is unlikely to sustain its gains due to upcoming fiscal risks.

One reason for the sterling's rally is the short squeeze and one-off flows. Speculators had turned bearish on sterling ahead of UK local elections in early May, which led to a surge in options market risk reversals. Sterling failed to sell off after the election results, and analysts suspect that large one-off sterling buying flows caught the market exceptionally short.

While some analysts point to M&A activity as a reason for the rally, ING argues that this story is probably being overstated. UK-targeted M&A flows have picked up this year due to the view that UK corporates are cheap, but current price-earnings multiples for the FTSE 250 trade at a steep discount to the S&P Euro index.

The real driver ahead is the Bank of England, with implied fair value consistently acting as an anchor around 0.86. The fair-value estimate is derived from a 10-year weekly relationship between EUR/GBP and the EUR:GBP 2Y swap spread. Analysts at ING expect EUR/GBP to rise towards 0.88 by year-end.