The British pound is likely to rise further against the euro in the near term despite its fall on Tuesday as it is still seen as a safe play, but in the long term it will weaken, according to currency analysts.
The pound fell against the euro and the dollar on Tuesday after UK manufacturing data came in at the weakest since December, when the index was in contraction territory. Analysts had expected the UK economy, which has officially entered a double-dip recession, to strengthen, allowing the Bank of England to shift its focus from growth to inflation.
"In the near term the risk is still on the downside in euro/sterling," John Hydeskov, chief analyst at Danske Bank told CNBC.com.
"We see euro sterling trading around 81 in a three-month horizon with the risk of dipping just below 80. We're talking about fairly narrow range trading," he added.
Behind sterling's strength against the euro in the past several months lies more than just the Bank of England's more hawkish stance in recent meetings, David Bloom, a currency strategist at HSBC wrote in a market note.
While it is true that with U.S. and euro zone monetary policy "at a standstill" markets will attach more significance to actions by other central banks, things like fiscal discipline, international foreign exchange reserves, the risk-on-risk-off trade and currency flows from mergers and acquisitions are all factors pushing sterling higher, according to Bloom.
"Despite growing political unpopularity, the coalition government has stuck to its fiscal targets, and met its borrowing target for the fiscal year just ended. This fiscal credibility may be encouraging a more favorable attitude from global investors," he wrote.
Global foreign exchange reserves held in sterling have started to grow again, Bloom added, a point reinforced by Bank of Tokyo-Mitshubishi UFJ analyst Lee Hardman, who noted that the Swiss National Bank (SNB) revealed on Monday that it increased the pound's share of its foreign reserves to 8.5 percent in the first quarter from 4.3 percent in the fourth quarter of last year.
However, Hardman added that "it would be an exaggeration" to say that the SNB's buying of pounds had a sustainable impact on the currency's direction during the quarter.
"We remain skeptical recent pound strength can be sustained, especially against the U.S. dollar and yen as it is highly unlikely the UK economy will decouple from the euro zone, likely prompting additional monetary easing from the BoE ahead," Hardman wrote.
Another factor sustaining the pound is the fact that it is seen as little affected by the risk-on-risk-off trade and therefore is considered a safe haven, Bloom said.
But, he added, the most significant factor may be the flows from mergers and acquisitions, as since mid-2009 there has been a recovery in the number of cross-border deals, although the overall value has remained relatively low.
"Of course, M&A flows are erratic, and tend to be dominated by a relatively small number of large deals, so there is no guarantee that this inflow will continue," Bloom said. "While these flows are erratic, they have the potential to keep GBP firm for a while longer."
Hydeskov warned against believing the pound is "massively undervalued," arguing that UK gross domestic product is still 4 percent lower than what it was before the crisis.
"I don't think the Bank of England is ready to tighten monetary policy," he said.
The central bank's quantitative easing program – under which it bought UK government bonds, also known as gilts – has not really stimulated the economy as intended and the bank probably needs to do a different kind of stimulus, according to Hydeskov.
"The second round [of quantitative easing] has been a disappointment, and I think the Bank of England is a bit envious with the ECB because it introduced the LTROs … that's not printing money, it's still keeping the risks on the balance sheet, the banks are doing QE for the ECB," he explained.
The Bank of England could lower its rate to zero from 0.5 percent or could buy other assets – such as covered bonds or mortgage-backed securities – besides gilts, according to Hydeskov.
"I wouldn't be surprised if we see a bold move from the Bank of England next week. It would be disappointing if they do nothing," he said.