Pound Reaches 18-Month High Versus Euro

The pound advanced to its strongest level in almost 18 months against the euro after the European Central Bank cut its deposit rate below zero for the first time and announced further measures to counter deflation threats.

Sterling gained versus the dollar after the Bank of England kept the main interest rate unchanged at a record-low 0.5 percent. While a worsening in the economic outlook and a prolonged spell of slow inflation prompted the ECB to inject more stimulus, in the U.K. the debate is about when officials will raise rates. The British benchmark will rise to 1 percent by the third quarter of next year, according to economists surveyed by Bloomberg.

“It’s a function of the expectations of divergence in terms of how they will be dealing with monetary policy, with the ECB looking for more stimulus measures, and indirectly would be looking for a lower euro,” said Neil Jones, head of hedge-fund sales at Mizuho Bank Ltd. in London. “Sterling is outperforming in part because of the expectation that the next move, as far as the Bank of England goes, will be higher.”

The pound gained 0.2 percent to 81.90 pence per euro at 4:30 p.m. London time after appreciating to 80.65 pence, the strongest level since Dec. 12, 2012. Sterling rose 0.4 percent to $1.6802, having slipped yesterday to $1.6699, the weakest since May 29.

ECB President Mario Draghi and his colleagues reduced the deposit rate to minus 0.1 percent from zero, making the institution the world’s first major central bank to set a negative rate. Officials also lowered the benchmark refinancing rate to 0.15 percent from 0.25 percent.

Economic Outlook

Europe’s 18-nation currency declined against most of its 16 major peers after Draghi said the ECB would introduce, targeted offerings of liquidity to banks to encourage them to lend money to the real economy. Officials will also start work on purchases of asset-backed securities, he said.

Sterling has jumped 8.8 percent in the past 12 months, the best performer among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes. The euro rose 3.2 percent, while the dollar slipped 1.2 percent.

The policy divergence is reflected in bond markets, with returns on U.K. government bonds this year trailing those on their euro-area peers by an average 2.5 percentage points, according to Bloomberg World Bond Indexes.

‘Clear Decoupling’

The yield on 10-year gilts was 87 basis points, or 0.87 percentage point, more than that on similar-maturity French bonds, up from a 2014 low of 35 basis points on Jan. 13, based on Bloomberg generic yields. That’s the widest since May 2007.

“There is a clear decoupling” in economic performance and monetary policy between the U.K. and euro area, Patrick Jacq, a fixed-income strategist at BNP Paribas SA in Paris said before the central bank decisions. “For the U.K., we expect there will be a rate hike by the end of the year and the market will gradually position for such an outcome.”

That difference will expand to about 1 percentage point by the end of 2014 as the U.K. 10-year yield rises to more than 3 percent and its French counterpart moves “just above” 2 percent, Jacq said. The median of economists’ estimates compiled by Bloomberg is for the 10-year gilt yield to increase to 3.30 percent while the French rate climbs to 2.30 percent.

Benchmark 10-year gilt yields fell two basis points to 2.68 percent. The 2.25 percent security due September 2023, rose 0.185, or 1.85 pounds per 1,000-pound face amount, to 96.535. The rate on similar-maturity French securities fell four basis points to 1.80 percent.

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