Investment Line: Can sterling's post-election honeymoon last?

Despite dire warnings about what a coalition government would do to the currency, sterling has performed rather well in the seven weeks since the UK general election. But can it retain its strength against its rivals for much longer?

Certainly, predictions that a UK coalition government would spell disaster for the currency have so far proved completely unfounded.

On 29 June, the pound reached €1.2331 against the euro - its highest level since10 November 2008 - while against the dollar it hit $1.51 for the first time since just before the election at the start of May.

But while its relative strength against the euro is perhaps less surprising given the onerous debt levels and impending austerity packages afflicting much of the eurozone, some experts are expressing surprise that it continues to do well against the dollar.

Capital Economics however, is predicting that sterling will fall back to around the $1.40 mark by the end of the year while continuing to strengthen against the euro, reaching around €1.40 by the end of 2010.

Analyst John Higgins sees little reason to change that forecast against the euro, although he notes there has been a slight rally by the euro against the dollar as the worst case scenario of complete European financial meltdown appears to have been averted-for now.

But before eurozone investors breathe a huge sigh of relief, Higgins warns that the prospect of a sovereign funding crisis has not completely gone away.

Government bond yields for Portugal, Ireland, Greece and Spain have actually climbed significantly since the €750bn European Union/IMF bailout agreed in May.

The downside of the financial rescue package is the huge fiscal squeeze that will accompany it. Higgins anticipates that the austerity packages that will have to be driven through by some of the most indebted EU member states may actually outstrip the effects of the UK's own fiscal measures.

Given that today's Guardian is quoting Treasury leaks estimating the UK's spending cuts will account for around 1.3 million job losses by 2015, that is a sobering thought.

The squeeze could be exacerbated by extreme wage restraint in the worst affected countries and possibly even wage cuts as countries look to regain international competitiveness, Higgins warns.

He predicts that the Greek and Spanish economies will shrink in 2011 and may do no better than zero growth for the following year, while the chances of a member state defaulting further down the line due to a populist backlash against the fiscal pain imposed upon them cannot be ruled out either.