By Tamawa Desai
LONDON, Sept 30 (Reuters) - Sterling will underperform other major currencies through year-end with UK policymakers appearing content for the currency to weaken, and with a tepid economic recovery keeping interest rates pinned to the floor.
The pound is on track for a decline of around 3 percent on a trade-weighted basis in September, its steepest monthly fall this year. Against the euro, analysts say a move towards parity cannot be ruled out in the coming quarter.
Sterling's latest downward move has been given extra impetus by comments from Bank of England Governor Mervyn King and, before that, a BoE report saying the pound's long-term exchange rate may have fallen due to the financial crisis.
"Near-term risks for sterling are to the downside due to comments from the Bank of England," said Phyllis Papadavid, currency strategist at Societe Generale.
Currency strategists at BNP Paribas see the pound falling to around $1.53 by year-end, near levels seen in May, but still higher than a low of $1.35 hit in January. The pound traded around $1.61 on Wednesday.
"Sterling will stay weak for the next two to three years, and is likely to be the underperformer among the majors," said Hans Redeker, global head of forex strategy at BNP Paribas in London, adding a deflationary environment would allow the currency to weaken without fear of igniting inflation.
In an interview last week, King was quoted as saying sterling's falls against major currencies were helping a much-needed rebalancing of the British economy towards exports.
This fits with the Group of 20 nations' stated goal of restoring balance to the global economy, whereby consuming and debtor nations like Britain and the United States would save more, and exporters and savers like China would spend more.
Finance Minister Alistair Darling has since said the government has no policy to deliberately weaken sterling and policymakers have expressed frustration at the way markets intepreted King's remarks.
However, many in the market subscribe to the idea that a weak pound would be a good thing.
Against the euro, some say sterling may fall even more sharply, possibly towards parity. It was trading around 91 pence on Wednesday.
"The pound looks set to hold broadly steady against a weak dollar, but a slide towards parity against the euro is looking more and more likely all the time," said Standard Bank strategist Steven Barrow, who sees the pound holding near $1.61.
Technical analysts say a break above the 94.80 pence level would pave the way toward parity. The euro hit an all-time high of 98.05 pence last December.
ROCK-BOTTOM RATES
Underpinning sterling's weakness are rock-bottom interest rates and speculation the BoE will further loosen monetary policy by expanding its programme of quantitative easing.
UK interest rates, along with those in the United States, are set to remain low for longer than those of other major industrialised economies because the effects of the global financial crisis are seen taking a bigger toll on those economies, making sterling less attractive.
The British economy contracted 5.5 percent year-on-year in the second quarter. Even when growth resumes as expected later this year, a recovery is seen sluggish.
That will keep speculation intact the BoE will expand its 175 billion pound quantitative easing programme in November, when the plan runs out of funds.
That is in contrast to other central banks, which are seen drawing down some of the emergency liquidity measures taken to combat a global liquidity crisis last year.
The BoE last expanded the programme by a bigger-than- expected 50 billion pounds in August. Then, King and two other members of the monetary policy committee wanted an even bigger increase. In September, they voted unanimously for no change.
But some analysts say the structural background may be favourable for the pound further out into next year.
"Capital inflows are picking up, and trade-weighted sterling is one of the most undervalued among the G10," said SocGen's Papadavid.
Sterling also took a hit this month from a BoE report which said the pound's long-run sustainable exchange rate may have fallen due to increased focus on Britain's economic imbalances.
It said changes to Britain's relative economic outlook, the perceived riskiness of UK assets and the need for the economy to rebalance away from domestic consumption had all played a role in sterling's fall over the past two years.
Trade-weighted sterling has averaged around 92.3 in the past two years, compared with an average of 99.7 in a 10-year period going back to 1997. The index was at 79.3 on Wednesday.
(Editing by Nigel Stephenson)