By Jamie McGeever
LONDON, May 14 (Reuters) - Only a few months ago sterling was in freefall but an improved technical picture, market positioning, and signs the UK economy may starting to stabilise suggest the only way is up, even if it's a crooked path.
Sterling collapsed by almost 20 percent in the months immediately after the Lehman Brothers collapse.
That was a bigger fall than the aftermath of crashing out the Exchange Rate Mechanism in 1992 with the helping hand of George Soros, and invoked memories of the 1976 crisis when the UK sought assistance from the International Monetary Fund.
However, some long-term valuation measures now suggest sterling is by far the most undervalued major currency and, despite the Bank of England's sober assessment this week of the economy's recovery prospects, markets are much more willing now to give sterling the benefit of any doubt.
"It is increasingly likely that the pound bottomed out at the end of last year, laying the foundations for a recovery," said Lee Hardman, currency strategist at BTM-UFJ in London.
"There are now tentative signs emerging that the aggressive easing in monetary conditions will translate into relative outperformance for the UK economy," he said.
The BoE has slashed interest rates to a record low 0.5 percent and embarked on a quantitative easing programme buying up to 150 billion pounds of government and corporate bonds in a bid to fight deflation, boost growth and kickstart lending.
Currency investors have given the pound the benefit of the doubt, shrugging off the potential long-term inflationary impact of these measures and focusing instead on their positive effect on growth.
"Sterling is the most undervalued relative to its long-term trend ... (although) the currency has bottomed out as the BoE's unprecedented step to introduce quantitative easing is showing some initial signs of success," said Geoffrey Yu, currency strategist at UBS in London.
Hardman reckons that the low in BoE's trade-weighted pound on Dec. 30 of 73.30 <=GBP> and sterling/dollar's $1.35 on Jan. 23 will be the lows for the cycle.
UNDERSHOOT
A recent Reuters poll showed that sterling was the most undervalued G10 currency. [ID:nL5181190] UBS analysts calculate sterling's real effective exchange rate (REER) was undervalued at the end of the first quarter by 23.7 percent relative to its long term trend.
That was by far the biggest undervaluation of the 12 major currencies tracked, with the Korean won and Japanese yen's REER next, undervalued by 16.3 and 14.8 percent respectively.
HSBC's currency strategy team reckons sterling's REER is undervalued by around 20 percent.
Most indicators show the economy is still in recession but the rate of contraction is slowing. Manufacturing and industrial production fell less than expected in April, while declines in service sector activity and house prices appear to be slowing.
And unemployment figures, by consensus a lagging indicator, on Tuesday showed joblessness in April rising much more slowly than economists had expected, even though the unemployment rate jumped above 7 percent for the first time in 12 years.
POISED FOR SNAP BACK?
A number of technical and market positioning indicators also show sterling has emerged from its July-January decline and is poised to recover further.
Its bounce in recent weeks has lagged that of other relatively high-yielding currencies like the Australian and New Zealand dollars which also plunged in the fourth quarter of last year, suggesting it has room to catch up.
The Aussie has rallied 8 percent and the Canadian dollar is up 7 percent against the U.S. dollar so far this quarter, while sterling has gained only 5 percent.
The latest available data from the International Monetary Market on the Chicago Mercantile Exchange show that the largest net short position in currency futures held by speculative trading accounts was the 22,437 contracts in sterling.
This is often a guide to future moves in exchange rates. For example large net short positions, or bets a currency will weaken, can be a sign market bets are too heavily skewed one way and that prices are poised to snap back.
Credit Suisse this week slashed its euro/sterling forecast to 84 pence from 93 pence over the next three months, anticipating that a relatively stronger UK economy and BoE eventually unloading gilts onto the market will boost UK yields.
"Markets should increasingly price for the BoE to exit quantitative easing by the fall, boosting yield spread support for sterling and counterbalancing some concerns about the larger-than-expected budget deficit," it said in a note.
The technical picture is also more encouraging for sterling than it has been for months, particularly against the dollar. Last week, the greenback broke below key technical levels at the 200-day and 200-week moving averages on a trade-weighted basis and versus the euro.
The pound has convincingly broken through $1.5069, the 23.6 percent retracement of its July 2008-January 2009 plunge that saw it slide to $1.35 from just above $2.00.
The medium-term outlook is bullish while the uptrend channel from mid-March holds, the base of which is around $1.4680. Assuming that holds, cable's next target will be $1.60, the 31.8 percent retracement of the July-January slide and broadly in line with what many analysts say is long-term fair value.