British GBP/USD Rate Reaches 5 Year Highs, But GBP/USD Forecasted Lower by Bank of America

For reference, we see the following rates at the start of the new week:

• The pound to dollar exchange rate is unchanged on Monday night's finish at 1.7029.
• The pound to euro exchange rate is at 1.2517.

Please be aware that the above mid-market quotes are subject to a discretionary spread levied by your bank. An independent FX provider will however seek to undercut your bank's offer and in some instances can deliver up to 5% more currency on execution. To learn more, please read here.

Why is the British pound stronger?

According to Charles Purdy at Smart Currency Business, "the key to sterling strength is the belief that we will see the UK increase interest rates this year thereby increasing the differential in interest rates with the euro and the US dollar."

This belief was undermined slightly by the lower than expected UK inflation figure, the minutes of the last Bank of England meeting which were less hawkish than expected and disappointing UK retail sales data.

The event triggered a sharp pullback in the sterling dollar exchange rate as traders saw this as the right time to close out of long positions.

Forecasting a weaker sterling dollar exchange rate

Don't expect a smooth run higher from here warn analysts at Bank of America Merrill Lynch Global Research.

In their latest foreign exchange forecast note analysts at the bank confirm they are sticking by their initial 2014 forecasts that called for a stronger USD:

"We expect GBP to weaken against the USD, as US data improve and the market position adjusts from stretched long GBP levels.

"We see a diminished likelihood of a significant near-term USD rally. But, we still see the risks in our outlook to the upside believing stronger growth and continued upside employment surprises could lead to higher inflation, which would imply a faster, USD-positive reduction in Fed stimulus."

Near-term rally in GBP shows signs of stalling

After rising to its strongest level since October 2008, the rally in the GBP/USD stalled right where it topped out in 2009.

For the past week we have been saying that the 1.7040 to 1.7050 zone is key and a clean break is needed for the currency pair to make run to 1.73.

"Unfortunately we haven't seen that clean break yet and with no major economic reports scheduled for release next week, it will be up to Mark Carney and the Bank of England' Financial Policy Committee's announcement to drive sterling to fresh highs," says Kathy Lien at BK Asset Management.

Near-term direction will be determined by the upcoming Financial Stability Report and the central bank must try convince the market that they are moving closer to raising rates.

"Sterling could find its way towards its next resistance level at 1.73, the 50% Fibonacci retracement of the 2007 to 2009 decline - but in all likelihood it will be a slow drift higher," says Lien.