Sterling slumped to its lowest level against the euro for four and a half years this week as the Bank of England laid the ground for cuts in UK interest rates and warned about the prospects for the UK economy in light of the credit squeeze.

Mervyn King, governor of the Bank of England, said UK growth would slow down sharply next year.

The warning came after the Bank on Wednesday released its quarterly inflation report, which suggested UK interest rates, at 5.75 per cent, would fall next year.

The central bank said UK inflation would remain on target even if it cut interest rates 50 basis points, as expected by the market.

On Thursday, figures showing a surprise drop in UK retail sales added to the pressure on the pound, fanning expectations that the central bank might even be prompted to cut rates before the end of the year.

Over the week, the pound tumbled 2.1 per cent to £0.7171 against the euro, lost 2.2 per cent to $2.0460 against the dollar and dropped 2.3 per cent to Y226.00 against the yen.

The yen surged to an 18-month high against the dollar as traders retreated from risky assets amid heightened nervousness over the state of the financial sector.

Analysts said sliding equity markets saw investors unwind carry trades, in which low-yielding currencies such as the yen are sold to fund the purchase of riskier, higher-yielding assets elsewhere.

This pushed the yen to a high of Y109.13 against the dollar on Monday, its strongest level since May 2006.

Comments from Yasuo Fukuda, the prime minister of Japan, helped stem the yen’s rise. He said the yen was appreciating too fast and warned traders and investors not to make speculative moves on the currency. He also noted that investors should be careful to avoid intervention from the Japanese government.

Analysts said the yen remained poised to strengthen further if the nervousness on financial markets continued.

“Stress in the financial sector and what is euphemistically referred to as the ‘lack of visibility’ continues to dominate the capital markets,” said Marc Chandler, at Brown Brothers Harriman.

“In the foreign exchange market it is expressed through the unwinding of short yen and dollar positions and long positions in higher yielding currencies.”

Over the week, the yen rose 0.2 per cent to Y110.50 against the dollar, climbed 0.4 per cent to Y161.80 against the euro and gained 2.6 per cent to Y98.30 against the higher-yielding Australian dollar.

The dollar also received a boost, rising 0.2 per cent to $1.4650 against the euro, climbing 2.5 per cent to $0.8890 against the Australian dollar and 0.9 per cent to $0.7570 against the New Zealand dollar.

Ashley Davies, at UBS, said the dollar had been benefiting from the renewed market uncertainty and waning risk appetite over past days.

“We continue to believe that risk aversion will prove to be a catalyst for a dollar recovery despite the threatening implications of the housing sector slowdown on the broader economy,” he said. “If there continue to be indications that the global economy is not impervious to a US economic slowdown, we expect appetite for risk investments into higher-yielding currencies to wane further as US repatriation picks up.”

The Canadian dollar fell 3.7 per cent to C$0.9790 over the week as trade data showed that the US slowdown and strength of the loonie were taking hold.

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