The pound defied expectations last week, strengthening against the dollar despite the Bank of England’s 1.5 percentage-point rate cut.

Stephen Hughes at currency specialist Foreign Currency Direct (FCD) said: “Normally when interest rates are cut, you expect currencies to weaken because investors are getting less interest or yield. However, we’re seeing sterling strengthen against the dollar.”

Prior to the rate-cut, sterling was at $1.58. The initial reaction caused it to fall to $1.57, but recovered to almost $1.60 before falling back to $1.56. On Friday it strengthened again to $1.58.

John Hardy at Saxo Bank said: “The surprising 1.5-point cut in UK base rates is at first glance bad news for the pound and prompts a knee-jerk selling reaction. But it is worth a second look — the size of the cut is aimed at aggressively stimulating recovery and this can only be good news for sterling. If equities see the cut as giving them the lift they need, we would expect sterling to consolidate its position.”

Against the euro there was a similar pattern. The pound fell on Thursday from €1.23 to €1.22 before rising again to €1.24 by Friday’s close.

However, investors bet that the UK economy would suffer a deeper recession than the eurozone economies. On Thursday the International Monetary Fund said the recession in the UK would be worse than in any other leading nation, with the economy expected to contract by 1.3% in 2009.

“There is some concern about the scale and depth of the problems facing the UK economy. The deterioration in the IMF’s UK forecasts is keeping sterling on the defensive,” Rabobank currency strategist Jeremy Stretch said.

Chris Turner at ING Financial Markets maintained his previous forecast that the pound could fall to $1.40 in the coming weeks. “We may even get to this point by the end of the year,” he said. He believes countries such as Russia, which placed up to 10% of its foreign-exchange reserves in sterling, have less to invest after the fall in oil prices.

Mansoor Mohi-Uddin at the investment bank UBS, is also sticking to his prediction of $1.38 by early next year. “Though we have seen a temporary bounce as investors are encouraged by the sharp rate cut, the overall picture for the UK economy is gloomy. Our economists also predict further rate cuts next year, bringing it [Bank rate] down to 2%.”

If you want to profit from weak sterling by bringing money back from America, use a broker rather than a bank. FCD provides three options for buying currency.

First, the spot contract allows customers to buy at a rate on the day.

Second, forward contracts allow you to lock in at a certain rate before you need the money. This can protect overseas property owners and buyers. Currency specialists allow you to lock in with a deposit of 10% for delivery up to two years ahead.

If you don’t think sterling will necessarily continue to weaken you could hedge — buy a forward contract for half of what you need and leave yourself open for the other half.

And third, there is a “limit order contract” where you stipulate at what level you would buy. You have to state an upper and lower limit. For example, you could say you want to buy dollars when sterling is at either a high of $1.65 or a low of $1.55.

This way, you benefit from a good rate if the currency strengthens, but you are also protected if it starts to slide, which could be useful if you are planning to buy a property abroad because you are guaranteed to receive a certain rate.

You have to pay for the currency two days after it is bought by FCD on your behalf. For the braver currency investor, spread betting is a tax-free, cost-effective alternative. It allows you to speculate on the movement of currencies without using a stockbroker, and therefore without having to pay commission or fees.

Spread-betting allows investors to “short” currencies, speculating that one will rise or fall against another. If you bet in the right direction, you make money. You lose if you get it wrong.

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