(Bloomberg) -- The pound rose to the highest since June against the dollar as traders bet resilience in the UK economy may give the Bank of England room to keep lifting interest rates.

Sterling rose as much as 0.9% to $1.2521 on Tuesday, taking its year-to-date advance past 3%, the best among the Group-of-10 currencies. The move came alongside broader weakness in the dollar in the face of evidence that the Federal Reserve’s tightening cycle is beginning to bite in the US economy. The euro also climbed and traded just below its highest this year. 

The UK currency’s revival in recent weeks followed months of pessimism, with investors having warned of stagflation risk as the country confronted double-digit inflation and a gloomy growth outlook. But markets have been surprised by the nation’s economy, with Deutsche Bank AG economists among those no longer forecasting a GDP contraction this year.  

“The growth data in the UK has not been as bad, and we should remember that the market expected a strong recession,” said Nordine Naam, a strategist at Natixis. “Inflation is still very high, which suggests that the BOE will continue to raise interest rates as a result, which is probably also supporting the currency at the moment.” 

Meanwhile in the US, the picture has turned more gloomy, with a gauge of the greenback’s strength trading at its lowest level since early February. Softer US jobs-opening data on Tuesday bolstered speculation the Federal Reserve is approaching the end of its aggressive rate-hiking campaign, following evidence Monday that US factory activity contracted more than anticipated.

Tuesday’s rally in the pound was also boosted by trades being stopped out as the currency reached key thresholds. Large buy stops were placed in the pound-dollar pair above $1.2448, the highest level for the past cycle, according to two Europe-based traders who asked not to be identified because they aren’t authorized to speak publicly.  

While most investors are “shying away” from going long on the pound at the moment, according to Nomura International Plc strategist Jordan Rochester, technical analysis suggests that there could be a further advance to come.

Seasonality could also play a role. Since 2001, the pound has gained against the dollar in April in all but four years.

Falling gas prices and improving terms of trade have also benefited the euro, spurring traders to turn more confident that the European Central Bank will also be able to keep raising interest rates even as the Fed pauses. The common currency rose as much as 0.6% to $1.0964, the strongest since early February. Natixis’ Naam sees those gains extending, forecasting a $1.12 level by September. 

Euro Rally Puts $1.10 in Sight With ECB Now Last Hawk Standing

“The widespread fear of recession that was evident last autumn has proven groundless and we should see slow steady growth in Europe and the UK in 2023,” said Steven Bell, chief economist for EMEA at Columbia Threadneedle. “This all suggests the euro and sterling could continue to strengthen against the US dollar.” 

European Rebound

In Europe, Bell pointed to signs that consumer spending in Germany could start to improve following an increase in confidence and falling energy bills. Waning concern that the banking turmoil in the US will spread to Europe could also give grounds for further policymaker hawkishness, with ECB Governing member Robert Holzmann saying this week a 50-basis-point hike was still on the cards in May.

Still, the positive outlook for European currencies largely depends on how US economic data evolves. Any sign that inflation proves stickier or that the impact on US credit conditions is more subdued could prompt traders to foresee a more hawkish Fed, which would offer support for the dollar.

“We believe that more data is needed to confirm a sizeable slowdown of the economy, especially given how strong the services sector seems to be,” said Mizuho International Plc strategists including Evelyne Gomez-Liechti in a note to clients.

Markets are currently wagering on less than a 50% chance that the Fed will raise borrowing costs by a quarter-point in its upcoming meeting, while betting on at least 75 basis points of rate cuts by year-end, according to swaps linked to meeting dates. In contrast, traders are not pricing a 25-basis-point cut from either the ECB or the BOE this year, and are betting on further tightening.

--With assistance from Alice Gledhill, Vassilis Karamanis, Naomi Tajitsu, Eddie van der Walt and James Hirai.

(Updates rates throughout and adds US jobs data in fifth paragraph.)

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