Domestic investors have been responsible for impressive sterling gains through the course of 2012; and once we take this factor into account we can see the pound sterling looking vulnerable. This is according to an analysis from Deutsche Bank which has forecasted the euro pound exchange rate to register further gains as the UK simply lacks the fundamental underpinning to sustain sterling-strength. Indeed, sterling’s Trade Weighted Index (a fundamental assessment of the UKs trade books) remains near five-year highs in spite of the weakest recorded recovery in UK history. "One commonly held view is that the pound benefits from a perceived safe-haven status, with foreigners attracted by the sovereign’s AAA credit rating and relative political stability when compared to other developed markets. As previously noted, there is little empirical support for this theory," says Oliver Harvey at Deutsche Bank. The most recent data indicates foreigners made a small net purchase of gilts in July, but over GBP 10bn was liquidated between April and June, which stands in marked contrast to ballooning inflows in countries like Switzerland and Sweden. "The key to sterling’s strength lies on the asset, rather than liability, side of the balance of payments. Recent periods of risk aversion have been accompanied by significant portfolio inflows from UK residents repatriating foreign assets, which have greatly outweighed corresponding foreign outflows," says Harvey. Given the importance of the UK financial sector and the size of London and Edinburgh’s asset management industry, Harvey says it should not be a surprise that domestic investor trends are the most important in determining sterling strength, particularly if large Eurozone holdings are being pared back.

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