Dealers reported that the pound was trading as low as DM2.7812, its weakest since joining the ERM. The Bundesbank and British Treasury rushed out denials that a devaluation was planned or expected. This helped push the pound half a pfennig higher, but the markets remained jittery in late trading.
The rumour came at the end of another tense day for the ERM. The mark weakened early when the Bank of Sweden was forced to more than treble its key overnight interest rate to 75 per cent. The huge rate increase was a bid to deflect speculation that Sweden would follow Finland's example and devalue the krona against the ERM currencies.
Dealers had been borrowing kronor and buying marks in the hope that a devaluation would mean the marks could later be sold back for a profit. By raising overnight interest rates, the Bank of Sweden made it more expensive for dealers to take this gamble.
The 75 per cent overnight rate was a record for Sweden, but pales in comparison to the 5,000 per cent overnight rates demanded by the Bank of France when the franc was under pressure in 1987.
The Swedish central bank also announced it had arranged an pounds 11.3bn loan of foreign currency with which to defend the krona. This dwarfs the pounds 7.25bn package to help the pound that Norman Lamont announced last Thursday.
The Swedish measures were well received and prompted selling of the mark. The pound rose above DM2.79 early on, before falling back to end the day a tenth of a pfennig lower at DM2.7868. Tensions in the ERM were also worsened by another opinion poll showing only a small majority of French voters expecting to back the Maastricht treaty on European union in the referendum on 20 September. The Italian lira - regarded as the first candidate for devaluation if the ERM is realigned in the aftermath of a French 'no' - remained close to its floor in the system.
The dollar performed strongly against both the mark and the pound, ending the day 1.65 pfennigs higher at DM1.4080, while the pound fell 2.5 cents to dollars 1.9785. The dollar was jolted lower in New York after President George Bush said its weakness was good for American exporters. But the currency was later boosted above DM1.41 when Wayne Angell, a Federal Reserve governor, said that it was 'extremely undervalued'.
The turmoil in the currency markets fuelled fears that Norman Lamont would eventually be forced to raise British interest rates in order to defend the pound and ward off pressure for devaluation.
The three-month interbank interest rate, which tracks City base rate expectations, rose by an eighth of a percentage point for the second consecutive day. It now fully discounts a half-point rise in bank base rates to 10.5 per cent.
The rumours of the comments by the Bundesbank officials caused a late flurry on the money markets, following reports from several economic news agencies. The agencies reported that a leading European commercial bank had circulated a private memorandum to its staff claiming that leading Bundesbank officials had confidentially said a devaluation of sterling, the lira and the peseta was inevitable, whatever the result of the French referendum.
The Bundesbank was also reported to have said that German interest rates would not be cut until growth in the M3 measure of German money supply had slowed. This meant that a German rate cut was unlikely until spring or summer next year, although a signal of lower rates could be given before the end of the year. Interest-rate cuts were then expected to be gradual.
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