Foreign Exchange Report 19 April 2007

GBP

With inflation at a ten year high the City is preparing for the Bank of England to increase interest rates as soon as May taking borrowing costs to their highest for six years.

The decision on rates will be announced in the second week of May. Speculation is rife that Tony Blair is expected to announce he is stepping down as prime minister around this time with Chancellor Gordon Brown, stepping up as Labour leader.

As Mr Brown was expected to fight for the leadership based on his successful stewardship of the economy it would be an embarrassment to be facing an election with a background of rising interest rates and inflation.

Inflation in March was 3.1% by the government's preferred consumer price index (CPI), the highest since 1997. Retail price index also jumped last month, to the highest since July 1991 at 4.8%.

The Bank of England's governor, Mervyn King, wrote an open letter to Mr Brown explaining why inflation had strayed more than a percentage point from its government-set target of 2%. This was the first time since Mr Brown set up the Bank's monetary policy committee that such a letter has been needed.

Mr King blamed a renewed rise in petrol prices as well as a surge in milk and a record 10% leap in furniture prices as stores put them up so they could cut them for the Easter sales.

Mr Brown responded to the note by writing his own letter saying the government would continue to "support the MPC in the forward-looking decisions it takes in the future". He vowed that the government would continue to be "vigilant and disciplined in the fight against inflation".

The Bank of England is widely expected to raise rates to 5.5% on 10 May and at least once more later in the year.

USD
During yesterdays trading, the Dollar was at its lowest level against Sterling since 1981, breaking through the $2.01 mark.

The greenback later eased back to $2.006 against sterling, but also slid to a two-year low against the euro.

The Dow Jones index fell in early trading, with strategists highlighting concerns about a slowdown in the US economy.

Sterling strength aside, US economic uncertainty and the fact that interest rates may have to come down to safeguard growth have largely been behind the dollar's weakness.

Sterling's rise above $2 is a consequence of both sterling strength and dollar weakness," said
Investors have said that "The paradigm is shifting, with investors now seeing Europe as a main engine for growth, with higher rates, and in turn they are shunning the dollar".

The European Central Bank is largely expected to begin a rate hike cycle as early as May. With higher interest rates increasing demand for a currency, investors will look to buy into assets that offer higher yields.

"The negative dollar sentiment right now is related to the US economy's potential for further slowdown and therefore rate cuts from the Fed," said David Powell, senior currency strategist, at IDEA global.

The US economy is expected to return to trend growth toward the end of the year. In the meantime, we could be in for a period of sustained dollar weakness and we expect that to be most pronounced against the euro and sterling in the coming days and weeks."