UK recession fears spark massive sell-off of sterling

The pound has slumped to a five-year low against the dollar, and is close to having its worst week since sterling was ejected from the European Exchange Rate Mechanism in 1992.

Sterling fell as far as $1.62 during yesterday's trading. Foreign exchange, gilts and equity markets all reacted strongly to the Prime Minister and the Governor of the Bank of England admitting that Britain is likely to enter its first recession in 16 years.

The turmoil in currency markets was reflected on world stock markets, as the FTSE 100 in London and the Dow Jones Industrial Average in New York plunged once again as company after company warned that the outlook for profits was deteriorating.

The pound dropped by more than 6 cents to $1.62, before staging a moderate recovery. Traders in London said major investors were selling the currency heavily, in the expectation that interest rates will be pushed sharply lower as the economy weakens. Sterling has now seen a depreciation of around 20 per cent against the dollar since its peaks in the summer of 2007, when it seemed clear that the US economy was heading into serious trouble but it was not certain the UK or other economies would follow.

Gordon Brown and the Bank of England governor, Mervyn King, both said that the country is likely to enter recession, and the admission was reinforced by the publication of gloomy minutes from the emergency Monetary Policy Committee on 8 October. The MPC cut rates by 0.5 percentage points then, part of an internationally co-ordinated move. With the oil price falling below $65 a barrel and inflationary pressures elsewhere fast crumbling, the way seems clear for some spectacular reductions in the cost of borrowing, and thus, the rewards for holding sterling. Some economists expect as much as a 1 percentage point cut when the MPC meets on 6 November; the consensus view is for a cut of at least 0.25 percentage points.

For those on mortgages with interest rates that track the Bank rate, it could mean a large boost in disposable incomes. Although the UK's Bank rate, at 4.5 per cent, is way above the US Federal Reserve's key federal funds rate, now down to 1.5 per cent, it is the anticipation of a sharply downward path in UK rates to possibly historic lows that has spurred the sterling sell-off.

Extreme observers believe rates will tumble to below 2 per cent next year – which would be the lowest rate in the Bank of England's 314-year history.

Analysts at Capital Economics said: "There was talk in both the MPC minutes and King's speech about the risk of an undershoot of the inflation target further ahead. The committee also sounded fairly cautious about how much good the Government's bank recapitalisation measures would do the economy in the near term, saying that the scale and timing of the positive impact of the programme 'was still highly uncertain'. We see rates getting to 2.5 per cent or even lower next year."

The FTSE 100 was shaken by the growing consensus that the economy is in for a sharp downturn. It closed down more than 4 per cent, off 189 points at 4,041 – and that was before the late sell-off in New York that took US shares down even further. Investors blamed forced selling by debt-burdened investors such as hedge funds, and the increasingly gloomy outlook for the world economy. The US is in the throes of the third-quarter earnings reporting season and a wide range of companies – from consumer products giant Kimberly-Clark and drug maker Merck, to online retailer Amazon and the tottering bank Wachovia – all warned that profits in the future would be lower than expected. The Dow ended last night down 5.7 per cent at 8,519. The 514-point decline was the seventh largest on record.

The White House announced that President Bush will host a summit on 15 November to discuss the global fin-ancial crisis and reforms to prevent it recurring. "The leaders will agree on a common set of principles for reform of the regulatory and institutional regimes for the world's financial sectors," said the White House spokeswoman, Dana Perino. Mr Bush has invited leaders of the G20, which includes the Group of Seven major industrial economies plus key emerging-market countries such as China, India and Brazil.