Sterling set for best month on euro in a year on rates moves, weakens on dollar

LONDON, March 31 (Reuters) - Sterling was set for its biggest monthly gain against the euro in over a year on Tuesday, due to the surge in British short-term borrowing costs, while also posting its biggest monthly fall on the dollar in five months as the Iran war roils markets.

Daily moves were fairly muted, versus the dollar, the pound bounced 0.16% off Monday's four-month low, while it was also a touch firmer on the common currency at 86.82 pence per euro.

But, on the month, the moves show the combined impact of the energy shock and short-dated interest rates.

Sterling has fallen 2.1% on the dollar in March, while the euro has fallen 1% on the pound, its most since February 2025. The pound has even risen 2% on the Swiss franc in March, its most in a month in two years, though threats by the Swiss National Bank to intervene to weaken its currency have also been in the mix there.

"Both the UK and the euro zone import more energy than they produce, so a supply-driven shock weakens each currency through terms-of-trade and growth channels, reducing household spending," said analysts at BNP Paribas in a note.

They said previous such energy shocks indicated a roughly 4% decline in the pound against the dollar in a scenario like this, and that the British currency would move roughly in line with the euro.

However, they said the pound had done better due to the relative change in interest rates.

Traders anticipate higher energy prices will force central banks to keep policy tight to prevent a surge in second-round inflation, and have changed expectations most dramatically for the Bank of England.

In late February, markets were pricing two BoE rate cuts this year, and now see at least two hikes. Moves have been less dramatic for the Federal Reserve - pricing has switched from two cuts to no change - and the European Central Bank - from no change to three hikes.

That has sent British rate-sensitive two-year yields up 94 basis points in March, the most since late 2022's British market turmoil, and more than in the U.S. or the euro zone.

And this has, in turn, supported the British currency despite the impact of the energy shock.

However, BNP Paribas also said it did not think sterling's outperformance would hold up "as the market prices in the growth and fiscal impact of the energy shock in addition to the terms of trade impact."

They recommend traders short the pound against the franc.

(Reporting by Alun John; Editing by Sharon Singleton)