The tide turns for sterling

Relief for exporters and interest rate cuts are now in prospect

THE POUND'S two-year rally against the currencies of its main trading partners looks set to snap, as expectations build that UK interest rates have peaked and Europe's new currency, the euro, will be strong.

Last weekend's summit on monetary union, with 11 countries selected as founding members, buoyed investor confidence in the euro's outlook. That is putting an end to the "safe haven" buying that helped boost the pound by 35 per cent against the mark since mid-1996.

The pound's other support - rising UK interest rates - has also run its course. Last week, the Bank of England left its benchmark lending rate on hold at 7.25 per cent for the sixth month in a row, and evidence of weak growth leaves little chance there will be another rate rise to boost the money-market return on sterling deposits.

"The tide for sterling has turned," said Mark Johns, bond manager at Guinness Flight Hambro Asset Management. "We've been switching from sterling to deutschmarks". He said this was on expectations that the pound would fall to between DM2.60 and DM2.70 by year-end.

The pound is already on its way down: it has slumped to a six-month low of DM2.90 from a nine-year high of DM3.11 on 31 March. Against the dollar it has fallen below $1.64 for the first time in two months.

Eight pfennigs of the fall against the mark have come since the weekend EMU summit, which also selected the leaders of the European Central Bank, easing Franco-German tensions by splitting the first term of the bank presidency between Dutch candidate Wim Duisenberg, backed by Germany, and the French nominee Jean-Claude Trichet.

"The focus has changed from `Will EMU happen?' to `Will EMU work?' and what kind of EMU it will be," said Steve Barrow, a currency strategist at Bear Stearns International.

The pound's decline is also partly due to the Bank of England's decision to keep rates at 7.25 per cent, which investors interpreted as a signal that the bank has finished raising rates after five quarter-point increases last year to slow inflation.

Sterling interest-rate futures contracts illustrate the shift in sentiment. The yield on the June contract is at 7.43 per cent, too low to signal a rate rise. The September contract slumps to 7.31 per cent, suggesting that some investors expect a rate cut by the end of the third quarter.

The pound fell again on Friday after the London Business School said sterling would fall to DM2.75 and $1.57 by year-end. The institute said economic growth would slow to 2.2 per cent this year and 1.7 per cent next year.

Growth was 2.8 per cent in the first quarter, slipping from 2.9 per cent in the fourth quarter last year and 3.4 per cent in the third. "There's no need to raise rates, so the central bank can start thinking about cutting rates," said LBS research fellow Alistair Barr. "This is the turning point."

A weaker pound could bring UK manufacturing back from the brink of recession. The fall has already boosted shares in European Colour, a UK pigment maker. The company makes 39 per cent of its sales in Europe and its shares gained 19 per cent last week as investors touted its potential for gains now that the currency is not such an obstacle.