By Amanda Cooper
LONDON (Reuters) - Sterling headed for its biggest one-week rally against the dollar in six months on Friday, as U.S. interest rates looked increasingly likely to plateau sooner than UK rates.
With the all-important monthly U.S. employment report due later in the day, activity in the currency market was subdued.
"From a cable perspective, this release may extend the rally (NFP miss or in line with estimates) or cap upside should the report come in stronger than expected," IG analyst Warren Venketas said.
The pound has gained 1.5% against the dollar this week, the most since early December, and nearly 1.1% against the euro - which would be its largest weekly increase in nearly four months.
The main driver has been a redirection of investor capital out of the safe-haven dollar, now that lawmakers in Washington have passed a bill that would suspend the U.S. government's borrowing limit.
Juicing up that flow has been a series of signals from Federal Reserve officials this week that the central bank might stand pat when it meets on June 13-14 to discuss monetary policy.
This has fed a sharp repricing in interest-rate expectations. Traders now place a 29% chance the Fed will raise rates this month, compared with a 70% chance a week ago.
Meanwhile, as UK inflation remains stubbornly high, traders have reassessed the outlook for monetary policy in Britain too.
Money markets show markets are pricing for UK rates to peak at 5.32% by year-end, up from 4.50% now. A month ago, the expectation was that UK rates would be around 4.80% by December.
Similarly, as U.S. Treasury yields have retreated with the passing of a bill in Congress to raise the U.S. government's borrowing limit and avoid a potentially catastrophic default, UK yields have ramped up, thereby giving sterling an advantage - at least in theory.
The premium of UK 10-year gilt yields over those for 10-year Treasuries has widened this week to its largest since early 2009.
In practice, however, sterling has not nearly as much of a lift as some might expect, given the 50-basis point premium that gilts wield over Treasuries.
Jordan Rochester, a strategist at Nomura, said in a recent note this is typical of an emerging market currency - a description often ascribed to sterling given its high volatility and sensitivity to domestic politics.
"Sticky inflation in the UK will prolong the length of the BoE rate hike cycle = lower growth, less UK inflows," he said.
Global growth expectations are waning, asset managers hold a small long position in sterling - giving them less incentive to load up on pounds - and the currency's correlation with bond yields is weaker than that say of the dollar with Treasury yields, Rochester said.
It's all down to stagflation. The UK has the highest inflation and the slowest growth among the G7. Britain has avoided recession, but the squeeze of the cost of living crisis on consumers and households is clear, given recent data on business activity, employment and lending.