The pound is also heading lower, analysts said, after a batch of economic reports last week confirmed that inflation is in check and economic growth is slow enough for the Bank of England to ponder an interest rate cut. Without any big economic reports this week, however, investors will focus on the global turmoil.
"We're in the lap of external factors yet again," said Jeremy Stretch, a currency strategist at NatWest Markets. With no economic data, "We're left with official pronouncements on the global environment."
World equity markets were falling last week on concern that slower growth worldwide is stunting corporate earnings. Analysts said more sharp declines might prompt the Fed and other members of the G7 nations to lower rates to give the global economy a boost. Lower UK rates would hurt the pound as they lower the return on sterling deposits.
The pound has weakened almost 4 per cent against the mark since late August on expectations of rate cuts as growth slowed in wages and prices and the manufacturing industry fell into recession. Bank of England Governor Eddie George's comment last week that the central bank would cut rates if inflation fell "significantly below" the Government's 2.5 per cent target also pushed the pound lower.
But at the end of last week the pound rose after investors concluded that the currency had weakened too much, given expectations that interest rates are not falling soon.
"The rate expectations were overdone," said James Barty, chief economist at Deutsche Bank. "Sterling has come down a long way, and it's not unusual for it to stall after a big drop."
While the pound strengthened on Friday, "the medium-term trend is for it to get weaker," Mr Stretch said. "The market anticipates lower rates by year-end."
The pound rose to DM2.8503 from DM2.8398 late Thursday. Against the dollar, it fell to $1.6811 from $1.6827.
The pound rose even as the Prime Minister, Tony Blair, told union leaders that he would like interest rates to come down next month or in November at the latest.
The Government reported last week that growth in wages slowed to an annual rate of 4.7 per cent in the three months to July, from 5.0 per cent in the second quarter. The underlying rate of inflation rose 0.4 per cent in August, taking the increase to 2.5 per cent for the year. The Government targets a 2.5 per cent rate. Last month was the first time it was on target since January.
The dollar rose against the yen on Friday on speculation that a plan to reform Japan's crippled banking system will not revive the Japanese economy soon.
"While this is good news, the outlook for Japan is still negative," said Mark Parry, at Hill Samuel Asset Management. "The Japanese economy is not going to change direction. We've had a negative view on the yen for some time, and still do," he said.
The dollar was at Y132.85 after dipping as low as Y131 after the plan was announced. The dollar fell to DM1.6905 on speculation that the Federal Reserve may cut interest rates before the Bundesbank, undercutting the dollar's allure compared with the mark.