'Sterling unlikely to sustain $2 exchange rate for long'

The pound is set for a rocky 2007, analysts believe, after racking up its biggest monthly gain against the dollar since Margaret Thatcher was still in Downing Street.

Sterling has risen by more than 14 per cent against the US currency this year, its best run since 1990. At one point this year it was up more than 15 per cent.

But the key engines behind the pound's rise - rising UK interest rates and a weakening US economy - could soon run out of steam. Most analysts believe the pound will breach the psychologically important two-dollar mark, as growing speculation of another rate hike by the Bank of England sustains interest in the pound.

The sterling/dollar exchange rate - known in the City as cable - will also get a lift from seasonal factors such as repatriation of UK monies and new heading contracts, according to Paul Mackel, senior currency strategist at HSBC. "There is no question that there are some seasonal factors that could see cable breach two dollars in the short term," he said.

However he warned that the pound would trade at around $1.90 to the dollar for much of 2007. "We do expect the dollar to be generally weak in 2007, but we also expect the pound will start to lose some of its shine," he said.

The key reason for his pessimism is that HSBC forecasts no rate rise in February and two quarter-point cuts in the second half of the year to 4.5 per cent. "It is likely we should expect cable to be on a tightrope walk in the third and fourth quarters of the year," he said.

However, Howard Archer, the chief UK economist at Global Insight, said the dollar would come under significant downward pressure during 2007 from softer US growth, further cuts in interest rates, and the massive US current account. He said that limited diversification of foreign exchange reserves by some central banks would also undermine the currency.

The arguments received support yesterday as the United Arab Emirates said that it would convert 8 per cent of its foreign-exchange reserves from dollars into euros over the next nine months. "The dollar's weakness is expected to lead to sterling trading above two dollars for an extended period in 2007, although we forecast the pound to lose some ground against the euro," he said.

Adam Cole, a senior currency strategist at RBC Capital Markets, said the pound would spend a "good part" of the year above two dollars. "This in due in large part to dollar weakness but also to sterling strength," he said. "The markets are treating the pound as an interest rate story."