The pound's upward breakout bolsters arguments for further long-term gains, but the swiftness of the recent rally limits the potential for short-term gains.
Over the past week, EUR/GBP has fallen below 0.85, approaching the year-end target of 0.84. This forecast remains more bullish on the pound than consensus estimates and forward FX markets.
The rally was fueled by a positive interest rate differential, stronger-than-expected UK economic data, and domestic political developments. Over the past month, the pound has been the best-performing major currency, despite investors maintaining significant short positions.
These short positions could have exacerbated the rally, as traders were forced to buy back the currency as it strengthened.
The short-term outlook for the pair has now shifted to neutral, as the EUR/GBP move has been sharp. Momentum indicators point to a possible consolidation before the pound resumes its sustained rise against the euro.
GBP/USD appears less overheated amid the dollar's recent recovery. A model that takes into account yield spreads on UK and US bonds, currency volatility, the pound risk premium, and the overall dollar trend estimates a fair value of around $1.33, compared to a spot rate of around $1.35.
This means the pound is only 1-2% overvalued against the dollar. A simpler model based solely on interest rates points to a much wider valuation gap, but it has underperformed in recent years.
Political events will increasingly influence the currency. The easing of uncertainty surrounding Andy Burnham's Labour Party leadership race initially supported the pound and UK government bonds.
Attention now shifts to the composition of the new government, its commitment to fiscal rules, and spending plans ahead of the November Budget. The gilt market's reaction will be an important signal for the pound.
Currency volatility is expected to remain subdued over the summer and then increase in the fourth quarter. The US midterm elections and the UK budget could trigger a significant increase in GBP/USD volatility.
Futures positions remain structurally short on the pound from 2025 onwards, making the currency vulnerable to further short-covering if UK data continues to beat expectations.