Sterling fell to its lowest level in a year on a trade-weighted basis and the yen strengthened on Monday as problems at Britain's Northern Rock bank heightened risk aversion and led investors to pare back carry trades.

The dollar steadied around half a cent away from the previous week's record lows versus the euro, with markets braced for a cut in U.S. interest rates on Tuesday.

However, continuing uncertainty in financial markets caused by problems at mortgage lender Northern Rock was the key driver of currencies.

It was forced to seek an emergency credit line from the Bank of England, leading investors to withdraw funds and fanning concerns that more financial institutions could be hit by high interbank lending rates.

Events in the UK money market driven by the run on Northern Rock are particularly disturbing as it takes the financial crisis across the Atlantic and drops it in London, said Teis Knuthsen head of FX research at Danske Markets in Copenhagen.

The pound is particularly vulnerable as the property market is vulnerable and the financial industry is such an important part of the UK economy.

At 7:25 a.m. the euro had risen as high as 69.51 pence, its highest level since July 2006. Against a basket of currencies the pound fell as low as 102.1, its lowest level in a year.

The low yielding yen was up 0.7 percent versus the pound at 229.52 yen and up 0.5 percent versus the dollar at 114.82.

The euro was steady at $1.3874, within sight of last week's record highs at $1.3927 according to Reuters data.


The market is convinced the U.S. Federal Reserve will cut the fed funds rate by at least 25 basis points from 5.25 percent on Tuesday to help cushion the U.S. economy from the housing market slowdown.

U.S. data on Friday showing an unexpected fall in core retail sales and weaker than forecast industrial output in August further boosted the case for lower U.S. interest rates

What currencies do will depend on what the Fed says as well as what it does, said Adam Cole, global head of FX currency strategy at Royal Bank of Canada Capital Markets.

If it cuts by 25 basis points but does not hint that it will cut further, it could hit risk appetite and support the yen at the expense of high yielders.

Starting with Lehman Brothers on Tuesday, major U.S. investment banks release their latest results this week, perhaps showing just how costly the credit squeeze has been.

Apart from being convinced the Fed will lower rates, markets are also increasingly pricing in a cut from the Bank of England. But the ECB is sounding a more hawkish tone.

Several policymakers from the European Central Bank warned over the weekend that inflation risks in the euro zone were still on the high side, leaving the door open for a tightening once credit markets calmed down.

Likewise, the Bank of Japan is still inclined to raise rates in the next few months even if it leaves them unchanged as expected this week.

U.S. Treasury Secretary Henry Paulson said on Monday he expected market turbulence to continue for a while, but noted that the backdrop was still one of global financial strength.

Investors will look to Paulson for further guidance on the markets when he speaks alongside UK finance minister Alistair Darling at 12:45 p.m.