Sterling surged to its highest level in more than a quarter of a century, rising above $2.01 yesterday as strong British pay numbers bolstered expectations that UK interest rates were set to rise further.
Average earnings in Britain rose by 4.6 per cent in the three months to February, the fastest pace in almost three years.
This, along with Tuesday's data showing that UK inflation had topped 3 per cent, pushed interest rate futures - financial derivative products whose prices reflect expected changes in interest rates - to factor in a rate rise in May and a further rise later in the year.
This would bring Bank of England rates to 5.75 per cent, making UK borrowing costs the highest in the Group of Seven rich countries, and it would encourage the more hawkish members of the European Central Bank's (ECB) governing council, who are arguing for increases in ECB rates.
"Going forward, the market will need to get a much better handle on where is the top on UK rates. This is constantly being challenged for an upward revision," said David Simmonds, head of FX strategy at Royal Bank of Scotland.
The Bank of England's minutes from its April meeting showed that policymakers voted 7-2 for steady interest rates, with the two dissenters voting for a hike from 5.25 per cent. By 1340 GMT the pound had risen as high as $2.0133. "We expect a rise above $2.0150, towards $2.0390 as a first target, before $2.0700, seen as the main level; above the latter, an extension towards $2.12 might be expected," BNP Paribas said in a note to clients.
Sterling hit a two-week high of 67.53 pence per euro.
Sterling was last at these levels in 1981. From there, the pound started a descent towards near parity with the dollar, hit in the mid-1980s as the UK economy suffered a downturn through high inflation and unemployment.
Sterling has been on a rising trend against the dollar since early 2006. The Bank of England has raised interest rates three times since August, giving the pound one of the most attractive yields among major currencies. The rising yield has also lured central banks looking to shift their swelling foreign exchange reserves out of dollars.
"Central banks are aggressive diversifiers," said Steven Pearson, chief currency strategist at HBOS Treasury Services. "Sterling, the euro and the Australian dollar are popular given the balance of liquidity and yield consideration."
"Dollar weakness in 2007 can be attributed to a relative deterioration in US economic fundamentals as well as a rise in implied inflation. Historically, a stagflationary environment has been bearish for the dollar," said Teis Knuthsen, chief strategist at Danske Bank. - (Reuters/ Financial Times Service)
