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Last Updated: Sunday, 6 August 2006, 14:09 GMT 15:09 UK
Sterling heading for $2 barrier
20 note
The pound has jumped in value against most major currencies
The shock rise in UK interest rates last week has sent the pound jumping higher against the dollar and other currencies, a trend that may continue.

Sterling rose more than two cents to $1.91 on Friday, a 15-month high.

Analysts think that as investors pile into sterling, the pound could near the two-dollar mark in coming months.

They expect the Bank of England to raise rates even further from their current 4.75%, presenting a good yield for those buying into the pound.

Sterling has also risen against the euro and the yen, helped by the fact that UK interest rates are higher than those in Japan and the European Union.

Bad for exporters

A high value pound has mixed implications for UK businesses and consumers.

We are revising our forecasts up, and do see the possibility of the pound hitting $2
Simon Derrick, Bank of New York

It makes UK exports more expensive on overseas markets, but it means companies buying raw materials in from abroad can get more for their money.

It also means that some imported items are cheaper in the shops, which is good news for consumers.

This can help keep a lid on the overall level of rising prices, known as inflation.

US flags fluttering in the breeze
Traders expect interest rates to stop rising in the US

However a strong pound is bad for the UK trade deficit, which hit a higher than expected 6.8bn ($12.4bn) in May as the country imported much more than it exported.

At the same time as the pound is becoming more attractive to currency traders, the dollar is losing its appeal - partly because the US Federal Reserve is expected to pause its cycle of raising interest rates.

The central bank's federal open market committee (FOMC) meets on Tuesday, to decide on whether to continue its series of 17 consecutive hikes, which have left the country's benchmark interest rate at 5.25%.

Currency traders have been switching their reserves out of the dollar in the belief that the Fed may hold steady, or if it does raise rates again, signal that it will stop there.

Weakening dollar

It is this divergence in monetary policy cycles - rates heading higher in the UK while looking set for a pause in the US - that economists believe will give the pound more upward momentum in the weeks ahead.

"We are revising our forecasts up, and do see the possibility of the pound hitting $2," said Simon Derrick, chief currency strategist at the Bank of New York.

Goods about to be shipped from Shanghai
A high value pound means foreign imports are cheaper

Sterling last reached the $2 mark in September 1992, just before the "Black Wednesday" crisis, when currency speculators forced the UK government to withdraw the pound from the European Exchange Rate Mechanism.

If the pound does pass the $2 mark, currency experts believe it will be a reflection of the dollar's weakness across the globe.

China has gigantic reserves of foreign currency, much of which is held in dollars.

"Since April there has been more and more comment from Chinese central bank officials about the composition of their reserves," said Mr Derrick.

"There is a definite feeling that they are uncomfortable with their weighting of dollars."

If the Chinese central bank starts selling noticeable amounts of its dollar reserves, it would weaken the dollar even more in the eyes of currency markets.

There are signs that other central banks are seeing sterling as a more attractive option, with the Bank of Italy announcing recently that it had slashed its dollar holdings and moved a quarter of its foreign reserves into the pound.

UK interest rates raised to 4.75%
03 Aug 06 |  Business
US Fed ups interest rate to 5.25%
29 Jun 06 |  Business
Why the dollar is falling so fast
15 May 06 |  Business
Weaker dollar hits world markets
12 May 06 |  Business

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