The prospect of another cut in British interest rates suggests that sterling should weaken, but the outlook for the pound is less clear-cut as it may find support from mergers and acquisition inflows, analysts say.
Sterling fell around half a US cent yesterday to $1.7366 after January inflation came in weaker than expected, suggesting that the Bank of England has room to follow up its August rate cut to 4.50 per cent with another move in coming months.
At the same time, interest rates are forecast to rise in the United States and the eurozone. Even Japan is seen on the verge of ending its quantitative easing policy, perhaps as soon as March.
"Ultimately we will see sterling coming under renewed pressure. There are few supportive factors which are just holding it in place at the moment, namely M&A activity," said Ian Stannard, senior foreign exchange strategist at BNP Paribas.
Foreign companies have been snapping up British firms and the resulting cash inflows are seen as a big positive for sterling, though analysts disagree on how long this may last.
"The M&A inflows have already been significant and I think there is potential for a lot more to come because the UK equity market is among the largest, relative to GDP, and among the cheapest at the moment," said Adam Cole, senior currency strategist at RBC Capital Markets.
"We see (sterling) strengthening on the back of mergers and acquisitions inflows," he added.
Shareholders of Britain's P&O on Monday voted in favour of a $6.8 billion takeover bid by Gulf state-backed Dubai Ports. Other possible takeover targets include airport operator BAA Plc, bank Lloyds TSB and the London Stock Exchange. Flows from foreign companies buying in to Britain in 2005 totalled $147.2 billion, according to financial industry data provider Dealogic.
But other analysts said mergers and acquisition activity was an unreliable and unpredictable source of support for sterling, adding that historically the currency tends to be driven by interest rate differentials.
"It's likely to prove to be fairly short term support. I think it will be interest rate expectations which will ultimately determine direction for sterling," said Mr Stannard at BNP.
Britain's comparatively high interest rates - which stood at 4.75 per cent before a 25 basis point cut in August - have helped attract investors in search of high yields.
Some also took advantage of Japan's zero interest rate policy to borrow the yen cheaply to invest in higher yielding currencies like sterling.