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Jobs, Not Inflation, Will Drive U.K. Rates

Tickers in this article: GBPUSD=X

NEW YORK (TheStreet) -- Against the dollar, the pound is trading at its highest levels in eight months. Recent rallies have been driven by minutes from the September meeting at the Bank of England, where policymakers voted 9-0 decision to keep stimulus programs on hold.

This is a significant difference from what was seen during the August meeting, when a dissenting minority saw a "compelling" need for policy changes that were more accommodative.

This is also an implicit suggestion that the BOE is confident that improving macroeconomic data indicate a sustainable trend.

The reduced potential for additional monetary stimulus has pushed the pound to gains of nearly 7% since the end first quarter, which is one of the best performances we have seen this year in developed-market currencies.

But, at the same time, it should be noted that the currency is still down nearly 30% from its 2007 highs against the dollar. At this stage, it is clear that in order for pound rallies to sustain themselves, we will need to see higher yields and a commitment to raising interest rates. Without this, the pound is in a precarious position and vulnerable to large moves to the downside given the strength seen in the last few months.

Supportive Data

To be sure, economic data largely support the Bank of England's more hawkish stance. The economy in England, the third largest in Europe, is expected to expand 1.3% in 2013 and by 2% next year.

This is slightly less than the GDP expectations for the U.S., where expectations rest at 1.6% for this year, and 2.7% for 2014. But England's August Purchasing Managers' Index (PMI) report showed that the service sector grew at its highest rate since 2006.

A broader measure, the Citigroup Surprise Index (which tracks positive and negative results in all economic releases, relative to market expectations) has risen to 72 this month after hitting lows of -33 in May.

But if we are going to see the higher interest rates needed to sustain long-term rallies in the pound, we will need to see the U.K.'s unemployment rate fall below the central bank's target of 7%.