Sterling braced for a pounding at hands of currency dealers

Sterling's slide against the dollar and the euro is expected to gather momentum this week as rapidly deteriorating economic conditions and growing expectations of UK interest rate cuts continue to hammer the currenc

The pound, which had been trading at around $2 for much of the year, fell below $1.86 at the end of last week and was not far off recent two-year lows of $1.8510. Currency dealers have sold sterling aggressively amid concern Britain will be among those major economies that could tumble into recession in coming months. Traders said sterling is now on its longest losing streak since February 2006.

The pound took a beating on Friday - the last session before the bank holiday weekend - on news that gross domestic product had plunged to its weakest level since 1992. This revived hopes in interest rate markets that the Bank of England will reduce the cost of borrowing, currently at 5%, by a quarter- percentage point by the end of the year and probably again by February.

The GDP figures are the strongest indicator yet - amid a crashing housing market, falling consumer confidence and inflation running at double government targets - that Britain is teetering on the brink of a recession.

"This is a pretty toxic environment for the pound," said Lee Hardman, a currency strategist at the London office of the Bank of Tokyo-Mitsubishi. "There's a risk of a rate cut in November if the data continues to deteriorate."

He forecast that the pound may drop below $1.80 in 12 months.

A growing number of City analysts say the dollar may be definitively emerging from a seven-year slump, during which it shed as much as 40% of its value. The dollar has gained strength on the premise that any recession that might hit America will be short-lived and the US economy will emerge stronger than those of Britain and the eurozone.

"It's not been a good week for sterling but ... it's more of a strong dollar story," said Paul Robson, currency strategist at RBS Global Banking.

He said the recent Bank of England Inflation Report sparked the latest round of selling, adding that there is an increasing probability the Bank of England could cut rates this year and will "almost certainly continue to cut through 2009".

Data published last week continued to paint a bleak picture of the economy. The Confederation of British Industry's industrial trends survey showed that manufacturers expect to cut output at the fastest rate in nearly seven years.

A report from the Office for National Statistics showed that bumper tax revenues from North Sea oil companies helped Britain's public finances swing into surplus in July, although the government still faces an uphill battle to meet its full-year borrowing forecasts.

Although the Bank has said a weaker pound will help take the sting out of the economic slowdown, eurozone demand for cheaper British goods may not take up the slack if the bloc's own economy proves too anaemic.

Interest rates might need to fall by more than markets expect to shore up an economy edging closer to the first recession since that of the early 1990s when hundreds of thousands of people lost their jobs and homes.

Last August, one euro bought 68p. Now, it buys more than 79p - a 16% rise in the value of euro, the currency of Britain's biggest trading partner. On a trade-weighted basis, sterling is down almost 14% on a year ago.

But analysts argue that a sharpening global economic downturn means there may be fewer lasting benefits from the weaker pound than rate-setters on the Bank's Monetary Policy Committee are counting on.

"The recent weakening in the outlook for the eurozone economy - the destination for around half of the UK's exports - suggests that there is a risk that activity in the UK will be even weaker than the Bank of England expects," said Paul Dales, UK economist at Capital Economics.

The UK economy has already slowed markedly in the last year, down from 0.8% growth on the quarter in the second quarter of 2007 to 0.2% in the same period this year, with analysts expecting a downward revision to 0.1%.

The Bank's latest inflation forecasts boosted expectations for lower interest rates, showing inflation falling below the 2% target in two years' time if rates stay at the present level of 5%.

Bank of England Governor Mervyn King also took the view that the weaker pound would help eventually to turn the economy around.

"The central projection is for output to be broadly flat over the next year," he said. "But further ahead, as food and domestic energy prices stabilise, the growth rate of real take-home pay should recover."

And that, together with some easing in credit supply conditions and a pick-up in exports following the fall in sterling's effective exchange rate, should support a recovery in output.