Sterling weakened on Tuesday, snapping a three-day rising streak as investors took profits, although expectations that Brexit talks will have a positive outcome continued to underpin the British currency. External factors have also proved supportive for the pound, recently with the US dollar struggling to gain much traction against its rivals in the opening days of the year.
"We expect to see progress towards securing a transitional deal (on leaving the European Union) in the coming months and that should be constructive for sterling," said Lee Hardman, a currency strategist at MUFJ in London. He expects the pound to rise to 1.40 against the dollar over the next six months.
On Tuesday, sterling weakened as much as 0.5 percent to $1.3504 but remained within striking distance of a four-month high of $1.3614 hit last week. Against the euro, it has been a more mixed picture, with sterling oscillating around the 88 cents line over the last month.
Jordan Rochester, a London-based FX strategist at Nomura, said sterling's weakness on Tuesday had been more about dollar strength. "Today is not a UK-specific story. It's more of a dollar and yen outperformance day," he said, referring to the Bank of Japan's decision to trim its purchases of long-dated government bonds in market operations.
Nomura expects the pound to strengthen this year as the Bank of England moves to hike interest rates faster than the market believes, Rochester added. The markets expect UK interest rates to rise only by the second half of 2018. A Reuters poll in December expects the next hike only in the fourth quarter of 2018.
With better-than-expected economic data in recent months and growing expectations a Brexit deal can be forged, traders have turned more positive on the pound. Net long bets on sterling are near their highest levels in more than three years, according to data released by the US Commodity Futures Trading Commission on Friday, suggesting some investors have warmed to the bullish sterling theme.
That optimism has also filtered through to the currency derivatives markets, with gauges of expected volatility plummeting to more than three-year lows. The drop in expected price swings has gathered steam since Prime Minister Theresa May secured progress in the complicated process of leaving the EU last month - so much so that expected volatility in sterling in options with up to one-year maturities is now below even some major rivals, such as the Japanese yen and the euro.
But some investors remain unconvinced that sterling is a buy, pointing to structural weaknesses of the British economy such as widening deficits. "We remain underweight on the pound as we see the balance of payments on a deteriorating trend," said Alessio de Longis, portfolio manager at Oppenheimer Funds, which manages $235 billion in global assets.