Pound Slumps Most in Week Versus Euro; Trichet Signals Rate Rise

The pound slid the most in a week versus the euro after European Central Bank President Jean-Claude Trichet said interest rates may rise next month, increasing the euro area’s yield allure over the U.K.

Sterling declined against the majority of its 16 most traded peers after Trichet said today that “strong vigilance” must be exercised as inflation risks deepened. The ECB left its main rate unchanged at a record low 1 percent. Reports in the U.K. showed house prices fell for an eighth month while service industries declined more than estimated, prompting Goldman Sachs Group Inc. to say Bank of England policy makers will leave the U.K.’s key rate unchanged to boost the economy.

“The ECB and BOE are taking different views on rates and inflation; clearly that’s why the euro is doing so well across the board, including against sterling,” said Ulrich Leuchtmann, head of foreign-exchange strategy in Frankfurt at Commerzbank AG. Trichet’s comments were “a massive surprise to the market. He’s basically moved rate expectations forward by five months.”

The pound lost as much as 1 percent to 85.76 pence per euro, the steepest intraday decline since Feb. 24, before trading at 85.75 pence per euro as of 4:43 p.m. in London. The British currency fell 0.4 percent to $1.6264, after rising to as much as $1.6344 yesterday, the strongest intraday level since Jan. 20, 2010.

Inflation ‘Persistent’

Sterling has gained 4.2 percent against the dollar this year amid mounting speculation that the central bank will raise interest rates from a record low 0.5 percent to quell an inflation rate that’s twice the government’s 2 percent target. Bank of England Deputy Governor Charles Bean said in a speech in London today that while inflation will be “more persistent” than policy makers forecast, the threat of rising prices needs to be weighed against the “downside risk to growth.”

The average cost of a U.K. home fell 0.2 percent in February from the previous month, London-based property researcher Hometrack Ltd. said today. An index of British service industry fell to 52.6 in February, according to Markit Economics Ltd. and the Chartered Institute of Purchasing and Supply, lower than the 53.7 forecast in a Bloomberg survey.

“These sets of data suggest the Bank of England will adopt a wait-and-see approach so markets might need to revise down their rate-hike expectations,” said Sarah Hewin, a senior economist at Standard Chartered Bank in London. “That will exert some negative pressure on the pound.”

MPC Split

Short-sterling futures fell, raising the implied yield on the contract expiring in December by seven basis points to 1.68 percent, following Trichet’s comments. A higher yield shows investors added to bets the Bank of England will raise interest rates.

Policy maker Andrew Sentance has led calls for the central bank to increase borrowing costs since June and last month voted for a 50 basis-point increase. Minutes from the bank’s Feb. 10 meeting showed Spencer Dale joined Sentance and Martin Weale in voting for higher borrowing costs, though they favored a 25 basis point rise.

Increasing the benchmark interest rate as a gesture in the fight against inflation would be “self-defeating,” Bank of England Governor Mervyn King told lawmakers in London this week. The next rate decision is scheduled for March 10.

“We remain of the view that monetary policy will remain unchanged in 2011 and that the first hike won’t be until next year,” said Hewin. “To raise rates fairly soon could potentially be very damaging to the economy.”

Money markets are favoring a 75 basis point increase by year-end, according to sterling overnight index average forwards, Tullett Prebon Plc data show. So-called Sonia rates indicate the first 25 basis point increase will happen in May.

U.K. two-year note yields, typically more sensitive to interest-rate expectations, rose six basis points to 1.45 percent. Yields on 10-year gilts increased eight basis points to 3.72 percent.

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