Sterling has been one of the few major currencies to appreciate against the US dollar over the past month. As a result the real effective exchange rate is now around 5% above its ten-year average and almost 15% above its ten-year trend. Despite the recent strength of the currency, we forecast it to fall back slightly against the dollar. A key reason is the relative prospects for UK and US monetary policy. Specifically, we think the gap between overnight rates in the US and UK will be higher over the next year or so than currently envisaged by both investors (based on OIS rates) and the consensus of economic forecasters.
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