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Sterling may hit $1.35 by year-end but rally will not last, analysts say

Sterling has seen quite a rebound after U.K. Prime Minister Theresa May surprised markets on Tuesday by announcing early elections. The currency surged to a six-and-a-half month high against the dollar on Tuesday trading around $1.28 levels.

While sterling has been driven higher on growing optimism that Prime Minister May will win convincingly, a number of analysts have warned the rally won't last.

"The market reaction is very rational given the response that we received. I think the fact that we are going to see a snap election, and we, and most other people expect the Conservatives to come back with a bigger majority," Mike Amey, a managing director and portfolio manager at Pimco, told CNBC Wednesday.

Sterling pound notes
Simon Dawson | Bloomberg | Getty Images
Sterling pound notes

Amey further explained that this takes the pressure off May's Conservative party in March 2019 in the run up to fresh elections as the U.K. exits the EU.

"I think the fact that sterling is up and gilts underperformed is fine. I think we look at where the markets are now and we think there is maybe a two-way risk on sterling, and U.K. bond yields look pretty low to us."

Surprising market reaction

However, some analysts say they were rather surprised with the market reaction on Tuesday after May's announcement. Kallum Pickering, senior UK economist at Berenberg, told CNBC via email that he was surprised at the positive market reaction.

"I don't see much merit to the story that an increase in Conservative seats following 8 June election May will dilute the hard-Brexiteers on the Conservative backbenches, enabling May to go for the softer Brexit that she wanted all along."

Pickering also said that the event yesterday has had no impact on the bank's sterling forecasts.

"No major change to my sterling forecast. Part dollar story, part Brexit story; markets pricing in 2018 Fed rate hikes and the potential for early clashes in the Brexit negotiations suggests that sterling will head a little lower from here for the rest of the year."

Sterling has seen a lot of volatility since the UK's vote to leave the European Union. While the initial moves were dramatic, plunging from the highs of $1.50 to a 31-year low of $1.32, the currency continues to remain under pressure at current levels of $1.28. Sterling is down more than 15 percent since referendum day.

Postcards showing the British Union flag, also known as Union Jack, sit on display at a souvenir store near to the Elizabeth Tower, also known as 'Big Ben', in London, U.K.
Luke MacGregor | Bloomberg | Getty Images
Postcards showing the British Union flag, also known as Union Jack, sit on display at a souvenir store near to the Elizabeth Tower, also known as 'Big Ben', in London, U.K.

The currency, however, saw a near 4 percent rally on Tuesday jumping from $1.25 initially and ending the trading day around $1.28.

Will the rally last?

But analysts have warned that this rally will not last. Vasileios Gkionakis, head of global fx strategy at Unicredit Bank, lists three reasons why the rally in sterling will not last.

"Firstly, UK data resilience is, to a large extent, reflecting the global growths pick up and we expect to see more sign of divergence over the quarters ahead as high inflation erodes UK real incomes and confidence," Gkionakis said in a research note.

Secondly, a more unified stance by the UK government is unlikely to improve Britain's bargaining position in the EU negotiations – in fact, it is likely to produce more friction with the other side, Gkionakis explained.

Finally, he said "once the French elections have concluded – and assuming that Ms. Le Pen does not make it to Elysee – the political risk premium currently embedded in the euro should be priced out. Based on real rate differentials, EUR-GBP is now trading around 6% lower than it should, most likely due to the election uncertainty in France. So, when the latter is priced-out we would expect a swift reversal towards the 0.88-0.90 range."

But some analysts continue to remain a little more upbeat about sterling. Philip Shaw, chief economist at Investec, told CNBC via email that he expects sterling to hit $1.35 by year end.

"Our view for a while has been that the risk premium embodied into sterling is excessive and that this will ease back over the course of the year as investors become more comfortable with Brexit-related uncertainties, allowing the pound to strengthen. By end-year, we are expecting cable at $1.35, although this is supported by a wider rally in the EUR vs the USD."

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