Interest rates appear certain to rise on both sides of the Channel: the only question is when. 

The Bank of England’s Monetary Policy Committee held rates at their historic low of 0.5 per cent in mid-March, a level now unchanged for two years. However, the CPI measure of inflation rose to 4 per cent in January – well above the Bank’s 2 per cent medium-term target – and governor Mervyn King has warned it could hit 5 per cent. 

Money markets still anticipate an increase in UK rates by May or June, but sterling, which had experienced a great run, has sunk back amid speculation that the European Central Bank will raise interest rates first. Jean-Claude Trichet, ECB president, recently spoke of the ‘strong vigilance’ necessary to deal with price pressures, in a stunt designed to support the euro. 

However, the situation is complicated because the ECB needs to set policy for the region as a whole, but divergences between countries have widened. A series of small quarter per cent rate increases – the consensus prediction – would push up borrowing costs in Ireland, Spain and Greece, and price Portugal out of the debt markets. 

It could pay to remember that Trichet also threatened higher rates last year and is now nearing the end of his term, and will not want to act hastily before he leaves his post in October. He will be aware that interest rates are a blunt instrument for dealing with inflation, and never more so than when the main culprits are rising prices in imported commodities and increases in indirect taxes. 

Any suggestion of a rate hike usually forces up the domestic currency, but traders are still nervous about the eurozone’s unique set of problems.  

‘Clients have been shorting the euro recently as it continues to strengthen following the news that an interest rate rise from the ECB could be imminent,’ says Angus Campbell, head of sales at Capital Spreads. ‘Their reluctance to go with the trend cost them a bit as the euro went higher, but for any of the few clients that have bought euro/US dollar they could be making a killing. 

‘Since the middle of January, €/$ has risen 7 per cent. Had you bought €/$ at 1.3000 on 12 January at £1 per point, by 7 March the rate had risen above 1.4000, so if you had sold at 1.4000 you would have made £1,000.’ (One point in foreign exchange spreads is 0.0001, so a move from 1.3000 to 1.4000 is
1,000 points.)

The pound/dollar rate has also gone from strength-to-strength, as investors increased bets that the Bank would raise borrowing costs and consolidate  the yield advantage the UK enjoys over the US. The pound broke the critical $1.63 barrier on 8 March, and David Jones, chief market strategist at IG Group, says we may now see sterling move back to its 2009 levels of $1.70.

However, there are drags on the pound such as the replacement in May of MPC hawk Andrew Sentance by Goldman Sachs economist Ben Broadbent, whose views are largely unknown. Indeed, Goldman analysts are predicting that the MPC will leave rates unchanged until 2012. The pound has also been hit by bad news from the British Retail Consortium as retail sales declined in February by 0.4 per cent.