Sterling stole the headlines in the currency market this week, surging 1.7 per cent to a 16-month high in trade-weighted terms after a surprise UK rate rise.

Some even saw the pound as primed for an assault on the near-mythical $2 mark, a level last reached in September 1992 prior to the Black Wednesday debacle and the pound's ignominious exit from the Exchange Rate Mechanism.

"The rate hike has put sterling in demand, and with the US dollar weakening, the pound will soon move above $2," said Hans Redeker, head of currency strategy at BNP Paribas.

The quarter-point rise in UK rates to 4.75 per cent was enough for the pound to rally 2.5 per cent to $1.9094 during the week, a 15-month high. Sterling also jumped 1.4 per cent to a seven-month high of £0.6752 to the euro, 1.6 per cent to a two-year high of SFr against the Swiss franc, and 2.5 per cent to Y217.84 against the yen, its highest level since October 1998.

Much of the optimism was based on the action in the futures market, which moved to fully price in another rate rise by February. Some went further, with ABN Amro changing its house call to predict rates will hit 5 per cent in November and 5.5 per cent in 2007.

But the debate was far from one-sided. Daragh Maher, senior FX strategist at Calyon, saw this week's rise as a one-off, with sterling "vulnerable to any indications that this week's hike was premature".

Even Mr Redeker warned that rate expectations were getting ahead of themselves and that the pound was now as overvalued in purchasing power parity terms as it was before its collapse in 1992.

Relative interest rate expectations were the prime driver. The euro was buoyed by a widely expected quarter-point rate rise, followed by comments from Jean-Claude Trichet, the president of the European Central Bank, that were deemed hawkish enough to set the stage for two further rises before the year is out.

But the dollar slumped yesterday when the release of weak US labour market data, including a rise in unemployment from 4.6 to 4.8 per cent, prompted the market to slash the prospects for an 18th straight rate rise next Tuesday from 40 to under 20 per cent.

The greenback slid 0.7 per cent to a two-month low of $1.2891 to the euro, cementing a 1 per cent weekly fall. It fell 0.7 per cent to Y114.12 to the yen - a weekly loss of 0.5 per cent - and 0.7 per cent to A$0.7655 to the Australian dollar, leaving the pair flat on the week.

Charles Shioleno, FX research analyst at Lehman Brothers, said: "The unemployment report was an unequivocal negative for the dollar and should trigger further weakness. The Fed seems to have been looking for an excuse to pause, and markets should now allow it to do so credibly."

Source:  Financial Times