Sterling extended broad-based gains on Thursday as investors pared back expectations of further stimulus from the Bank of England, putting the currency firmly on track to rise against the euro to levels not scaled since mid-2010.
The pound rose to its highest in nearly 20 months against the euro and a five-month high against the U.S. dollar>, all of which helped it to climb to a 20-month peak on a trade-weighted basket of currencies, data from the Bank of England showed.
More gains are likely as investors seek to exit the euro zone troubles and are wary of piling into the U.S. dollar as further easing by the Federal Reserve is still an option.
In contrast, minutes from the BOE's last policy meeting released on Wednesday showed the committee voted 8-1 against further stimulus, with one policymaker Adam Posen who had consistently voted for more stimulus moving out of the dovish camp and another now seeing the decision as finely balanced.
The minutes were the trigger, but sterling's gains undoubtedly show that investors who dislike the euro and the dollar are preferring the pound, said Adrian Schmidt, FX strategist at Lloyds TSB.
If sentiment in the euro zone remains as it is, we will find the 2010 low of 80.67 a bit tough to break. But if the euro zone troubles deteriorate, then that will go easily. In which case, cable could also come under pressure.
The euro fell to 81.625 pence, its lowest level since end-August 2010. Traders cite an option barrier at 81.50 pence with near-term support around 81.43 pence, a level seen on August 23, 2010. A break below that could see it ease towards 80.67 pence, the 2010 low struck in June.
A widening of spreads between 10-year German bunds and comparable UK gilt yields have also worked in favour of sterling against the euro.
Sterling rose to a five-month high of $1.6078, with talk of an option barrier at $1.61 likely to cap gains for now. It was marginally higher on the day at $1.6040 with Commerzbank chartists saying that the move above $1.6070, meant cable would target $1.6170, the October 2011 high and the 61.8 percent retracement of the move seen 2011-2012.
The medium-term trend for sterling also looked bullish on the charts with some pointing to a golden cross, with the 55-day moving average crossing the 200-day moving average.
A golden cross is formed when the former rises through the latter and last time it happened in September 2010, sterling rose from around $1.5400 to above $1.6500.
NOT A ONE-WAY STREET
Traders said while sterling was poised for more gains, a lot would depend on how the euro zone debt crisis panned out. A Spanish bond auction went through smoothly but borrowing costs have been rising as investors remain sceptical about whether peripheral countries can solve their fiscal problems without seeking more aid from multilateral agencies like the IMF.
While a steady erosion of confidence in the euro zone supports sterling against the euro, the pound tends to underperform the safe-haven U.S. dollar, given the UK's large exposure to the crisis-hit euro zone.
Also the UK's labour market is at best sluggish, domestic demand patchy and an economic recovery uneven. So while the signs of a slight recovery lessen the need for further stimulus, a rapid deterioration in the euro zone crisis could worsen the UK's outlook and drive the BOE towards easing.
We don't like the outlook for sterling due to weak government finances, low rates and weak growth. We are buyers of dollars above $1.60, said Mark Wright, deputy manager for the Midas balanced growth fund which is around 213 million pounds in size.
Inflation is quite sticky which in the medium term will deter buyers of sterling. In the medium term I'd envisage we'd further reduce our exposure to sterling.
On Thursday, BoE's Posen said he is worried that underlying inflation pressures have not eased in recent months and added if last month's pick-up in inflation persists, the central bank would need to rethink policy.
Sticky inflation and a weak growth profile are usually bearish for a currency, traders said.
(Additional reporting by Jessica Mortimer; editing by Ron Askew)