Sterling ended 2.17 pfennigs above Friday's close at DM2.5397, a level last seen shortly after the pound's exit from the European exchange rate mechanism last September.
Confidence in the pound has been buoyed by last week's comments from the Chancellor of the Exchequer, Kenneth Clarke, that he sees no need for a cut in British base rates at the moment. In contrast, the markets expect the Bundesbank to cut German rates next month and that rates elsewhere in Europe will also fall.
The pound opened strongly, following heavy buying in the Far East overnight. This was triggered by a survey of analysts by Idea, the financial information group, showing that almost half expect the pound to outperform other European currencies in the next three months. Sterling faded slightly during the afternoon, having met resistance around DM2.5450.
Steve Barrow, economist at Chemical Bank, said he expected sterling to trade around DM2.65-70 at the end of the year. 'I don't see this as a short- term move,' he said. George Magnus, of Warburg Securities, said it would be a struggle for the pound to progress much beyond DM2.60. He added that the Chancellor may cut British base rates again if the sluggishness of recovery forces further tax increases to get public borrowing down.
The pound also gained ground against the dollar, rising by just under a cent and a quarter to dollars 1.4935. But analysts said underlying enthusiasm for the US currency meant dollars 1.50 was likely to prove a tough psychological barrier for the currency to break.
Gilts also had a good day, as a newspaper report that France may pull out of the ERM if the Bundesbank does not cut interest rates more quickly encouraged investors to switch from Continental European markets. The French economics ministry dismissed the idea as 'completely unthinkable'. The market was in confident mood ahead of tomorrow's auction of pounds 3.25bn of 10-year stock, with the existing 8 per cent 2003 rising by pounds 3 8 to pounds 1027 16 .
The dollar's rise against the mark was held back by profit-taking - the US currency closed 0.17 pfennigs higher at DM1.7002. But most analysts believe the dollar is only taking a breather and will resume its climb.
Paradoxically, the mark rose slightly following unexpectedly subdued German inflation figures for June. The cost of living in western Germany rose 0.1 per cent between May and June, taking the annual rate of inflation to 4.1 per cent, according to provisional figures released yesterday. In May, western German consumer prices were up 0.3 per cent from April, and 4.2 per cent from the same month a year earlier.
The figures - based on inflation data from four of the 11 states in western Germany - were slightly better than expected, encouraging hopes that the Bundesbank may resume the process of gentle interest rate cuts when its policy-making council meets in Leipzig on Thursday.
Ulrich Hombrecher, economist at WestLB, said there was a 50/50 chance of a quarter-point cut in rates this week. The Bundesbank has been forced to launch a verbal defence of the mark in recent days, but economists do not think that this poses any fundamental obstacle to rate cuts.
Jurgen Pfister, economist at Commerzbank, described the mark's fall against the dollar as normalisation after a period of strength. He said the 'currency rate is important, but it will not prevent a fall in interest rates'.
At the weekend, Hans Tietmeyer, president-designate of the Bundesbank, said: 'The current exchange rate position seems overall to me to be appropriate for the German economy.' The Bundesbank has repeatedly issued assurances that the mark's anchor role is not in jeopardy.
Alison Cottrell, European economist at Midland Global Markets, said she expected the Bundesbank to wait until 15 July before cutting rates, although the low inflation figure increased the chance of a half-point cut.
She added that an early move would need the stimulus of good news on German government spending cuts. The cabinet is due to finalise its controversial programme for radical savings at a meeting on 13 July.
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