"Sterling has got a good economy behind it and rates have to go up," said Lee Ferridge, head of global currency strategy at Rabobank International. He expects the pound to rise to $1.65 by the end of the year, a gain of more than 2 per cent from Friday's rate.
The pound climbed to a 10-day high of $1.6156 on Friday. It slipped to $1.6044 by the close of trading, up from $1.5875 a week earlier. It rose to 0.6606 per euro after being near to a one-month low of 0.6626 earlier on.
Meanwhile, reports on retail sales and manufacturing are due on Tuesday as the Bank of England begins its two-day rate- setting session.
Higher interest rates could draw investors to the pound because a rise would mean that the return on sterling deposits increases in turn. Three- month pound deposits pay 246 basis points more than euro deposits, and 38 basis points less than dollar deposits.
While that is good news for investors, it is bad for UK manufacturers since a stronger currency means British exports are more expensive overseas.
"It would be bad for manufacturing for the pound to strengthen," said Rick Martignetti, assistant treasurer at Electrocomponents, the UK's largest distributor of electronic parts. At the moment "the huge differential [in rates] is what's keeping the pound high" against the euro, he said.
Policy makers at the Bank of England will decide lending rates on Wednesday. They voted to cut the benchmark re- purchase rate to 5 per cent in June in an attempt to stimulate growth amid evidence of subdued inflation. "Hopefully inflation will remain benign and the Bank of England won't be called on to raise interest rates," said Mr Martignetti.
Economists are split on whether the Bank of England will raise rates before the end of December. Eight out of a total of 15 economists in a Bloomberg News poll expected higher borrowing costs, while seven saw no change.
"November is the most likely time for the Bank of England to take back June's quarter percentage point rate cut," said Geoffrey Dicks, a UK economist at Greenwich NatWest. That was "an insurance policy" to avert recession in the UK, he said.
Bank of England rate-setters will be able to digest new reports on the economy on Tuesday when the Government releases figures on manufacturing and industrial production in July. The British Retail Consortium releases its August sales monitor and the CBI releases its distributive trades survey on the same day.
Some investors are betting that evidence of improved economic activity will persuade the Bank of England to raise interest rates before the end of the year.
The 5.68 per cent rate on the December sterling interest rate futures contract is 46 basis points more than current three-month lending rates, suggesting expectations for at least a 25 basis point increase in borrowing costs before then.