"The focus will be entirely on the Fed," said Steve Andrew, an economist at Merrill Lynch, who said he expects the Fed to ease rates by a quarter point at its 29 September meeting. "Sterling is going to remain attractive."
On Friday, the pound rose against the dollar to $1.6993 and advanced against the German mark to DM2.8431.
Speculation the US would lower rates grew last week on news that the Fed organized a bailout of a troubled US hedge fund. Concern that other funds may be facing similar problems may help push the Fed into cutting rates, traders said.
Fed Chairman Alan Greenspan fanned expectations for a cut in the federal funds rate, now 5.5 per cent, when he told the Senate Budget Committee last week that "deteriorating foreign economies" are likely to slow US growth enough to contain inflation.
While lower rates usually stimulate economic growth, they often weaken a currency by lowering money-market returns.
Mr Andrew expects the Bank of England to match a cut by the Fed, though not until later in the year. That could weaken the pound slightly in the coming months to about $1.60 per pound, Mr Andrew said, though rates will hold well above those in the US The Bank of England left its benchmark securities repurchase rate untouched at 7.5 per cent at its last meeting.
The return on three-month sterling deposits is 7.39 per cent while dollar deposits bring a 5.31 per cent return.
"The bank will probably be too cautious this year" and will wait to lower rates, said Simon Rubinsohn, manager at Capel-Cure Myers Capital Management and sees the pound rising in the short-term. "We expect to see only one rate cut this year, but rates will fall sharply next year" to 5.50 per cent or below by the end of next year.
The pound's rise could be curbed by a UK trade report to be released on Monday, which will likely show a further widening of the trade deficit. Economists expect that the August trade deficit with nations outside the European Union widened to pounds 1.1bn from pounds 949m.
The overall trade deficit was likely little changed in July from pounds 1.437bn in June. In the second quarter, the deficit was 5 per cent bigger than in the first three months of the year as the strength of the pound makes UK products more expensive abroad.
The pound is up 23 per cent against the currencies of its major trading partners since August 1996.
Mr Rubinsohn said he sees sterling rising to DM2.88 or DM2.90 this year, before falling to 2.65 next year. "We're cautious about sterling, but we don't think it's time for it to fall quite yet," he said. "If sterling were to recover, we would be looking to sell into that."
The UK reported last week that retail prices minus mortgage interest payments, the Government's preferred measure of inflation, rose 0.4 per cent in August, slowing the increase for the year to 2.5 per cent from 2.6 per cent in July. At 2.5 per cent, UK inflation is in line with the Government's annual target.