A sell-off in UK banking stocks led to a volatile time for sterling, which dipped to a two-and-a-half year low yesterday against the dollar.

A sell-off in UK banking stocks led to a volatile time for sterling, which dipped to a two-and-a-half year low yesterday against the dollar. However, analysts expect a smoother ride in coming months as the market, in a reversal of usual practice, reacts warmly to falling interest rates.

The pound had a strong start to the day after the Reserve Bank of Australia stunned markets by cutting interest rates by a percentage point, double what was expected.

As traders anticipated a wave of copy-cat actions by other central banks, the pound soared to $1.7640 before markets opened in the UK.

However, this was reversed as it emerged that UK banks had been in discussions with the government over a possible recapitalisation scheme, prompting a sell-off in domestic financial stocks.

This fed through to currencies, sending the pound down a low of $1.7322.

Sterling then went back up, climbing 1.9% to highs of $1.7657 as the market digested an announcement by EU finance ministers that they would protect savings deposits and work to recapitalise vulnerable banks.

This mark is still 11% below the $1.986 mark at which the currency started the year.

Nick Parsons, head of market strategy at NAB Capital said: "We have traded on four different big figures today against the dollar. It is fair to say it has been a pretty wild ride."

Analysts anticipate sterling holding up into next year as traders, who normally prefer currencies with rising rates, buy into markets where the rates are easing and reducing pressure on the financial sector.

Parsons said: "We are going to see some stability return to asset markets. I think we will see the pound supported around the $1.735/$1.74 area."

Next year, he anticipates the pound trading in the "high $160s".

But he added: "For the moment the fall has come to an end. It will fall a little bit into next year but for the moment the decline looks overdone."

Parsons anticipates a 50 basis points cut in UK interest rates to 4.5% tomorrow.

He added: "What we will see on Thursday is a cut of at least 50 basis points and we think there will be in total at least 100 basis points cut before Christmas and the market is going to look very different come Christmas time than it does today."

Parsons anticipates a fall in interbank lending rates which will feed through to "substantially lower" mortgage charges for borrowers by the end of the year.

Adam Cole, currency strategist at Royal Bank of Canada, said investors had changed their attitudes towards rate cuts.

"The market is rewarding currencies where the central bank is moving proactively. Very aggressive cuts have done the dollar no harm because it is seen as doing what is necessary."