Sterling recovered on Thursday after a session low versus the dollar after the Bank of England announced that it was keeping interest rates on hold at record lows of 0.5% despite some expectations of a hike. Some believe that high inflation will force policy tightening by mid-year.
Traders said speculators liquidated some long positions they had built in the last few weeks but sterling found solid support, with central banks and leveraged accounts cited as buyers at lower levels.
The BoE had been widely expected to keep rates at 0.5 percent, but markets had priced in a 20 percent chance of a rate rise. Traders said the hawks who were expecting that had cut their positions, leading to a brief dip in sterling.
"The money markets were pricing in a 20 percent chance of a hike, but no one really expected the BoE to go," said Chris Turner, head of FX strategy at ING. "The inflation report from the BoE is due next Wednesday and we expect them to be pretty hawkish there. So sterling will be supported by expectations of interest rate hikes. We see it at $1.70 by the end of the summer."
A rate hike is being largely priced in for May, while implied rates based on swaps rates show there is a nearly 22 percent chance of a rate hike in March.
Speculation of a near-term rate hike has gained momentum on expectations that annual inflation will pick up, having already hit an eight-month high of 3.7 percent in December, almost twice the central bank's target.
Minutes of the BoE's recent policy meetings have recorded a more hawkish tone, with two members voting for a rate hike last month. The minutes showed Martin Weale had joined Andrew Sentance in voting for rates to be raised, giving sterling bulls a huge boost.
Expectations of a rate hike have remained strong despite a shock contraction in Britain's economy at the end of 2010. Analysts said slowing growth prospects, lower government spending and rising unemployment could heighten the BoE's dilemma over when to tighten policy. Data on Thursday showed British factory output fell unexpectedly in December, but a weather-related surge in energy production offset the decline, and economists said they expected a manufacturing bounce-back in January.
The pound continues to gain vs the euro, up 0.6% yesterday, fuelled by market expectation that the BoE will tighten rates ahead of the European Central Bank. Gains have continued into this morning with GBPEUR opening near the high of the week.
The euro fell more than 0.6 percent against sterling yesterday, with near term support seen near its 200-day moving average which comes in at 84.529 pence.
The single currency was under broad pressure as worries about the Eurozone debt crisis and the lack of a quick solution were starting to emerge and as speculation waned that the ECB will raise rates soon. The euro, which hit a 12-week high against the dollar earlier this month, struggled as investors drove Portuguese bond yields to their highest level since the currency was introduced in 1999. Fresh concerns weigh heavily on the euro as new speculation emerged that Portugal is considered at risk of becoming the next Eurozone country to need a bailout. European leaders will meet next month to discuss bolstering a 440-billion euro bailout fund.
The dollar against its major counterparts, the Swiss franc being a major casualty as safe-haven demand faded on reports Egyptian President Hosni Mubarak looked likely to step down, pushing the greenback to a one-month high. The dollar also rose for a seventh straight session versus the yen, nearing a one-month high before finishing up 1.0 percent. Traders expect higher US yields to pull capital out of Japan, with analysts predicting they could soon reach highs not seen since last seen in July.