The pound edged up against the dollar and the euro on Thursday, but sank against the yen, as investor expectations mounted that the Bank of Japan could signal an end to its ultra-easy monetary policy next week.
Sterling lost 1.3% in value against the yen, its largest one-day drop against the Japanese currency in nearly five months.
The pound has held firm this month, after its biggest monthly rally in a year in November. Investors are gaining confidence the major central banks will cut rates early next year. But the Bank of England is likely to be an exception.
Futures markets show investors believe the first cut from the BoE might not happen until June, compared with March for both the European Central Bank and the Federal Reserve, which has helped limit any profit-taking on November's rally.
The catalyst for the yen's broad-based rally on Thursday was comment from Bank of Japan Governor Kazuo Ueda, who told the Japanese parliament the central bank has several options on which interest rates to target once it pulls short-term borrowing costs out of negative territory.
"The choice of wording – 'once', not 'if' – suggests the BOJ remains committed to normalising policy, most likely around the start of the fiscal year in April," City Index analyst David Scutt said in a note.
"But with markets bringing forward the expected timing and scale of rate cuts from other major central banks, such a move would be incredibly risky, creating a scenario that could send the Japanese yen sharply higher against currencies of its major trading partners."
The pound was last up 0.2% against the dollar at $1.2587 and up 0.1% against the euro at 85.65 pence. Against the yen, it was down 1.45% at 182.31 yen, its lowest since late October.
The BoE also meets next week. Markets expect it to leave UK rates unchanged, but they will scrutinise the post-meeting statement for evidence of how Monetary Policy Committee members voted and the central bank outlook on inflation and growth.
Futures markets show traders think UK rates could fall by around 80 basis points next year to below 4.40%, in contrast to the European Central Bank, which traders expect to implement around 140 bps in cuts, and the Federal Reserve, which could cut U.S. rates by around 120 bps.
Yields on 10-year UK gilts are trading below 4% at their lowest in seven months, having fallen 75 bps in the last six weeks. German 10-year yields, the benchmark for the euro zone, have dropped 80 bps and 10-year U.S. Treasury yields have fallen 90 bps.
The "higher for longer" scenario for the BoE has given sterling some support.
"When it comes to euro/sterling, the drop appears to be overdone, and we expect a gradual dovish repricing in Bank of England rate expectations to favour a rebound above 86.00, although that may not happen in the very short term," ING strategist Francesco Pesole said in a note this week.
(Reporting by Amanda Cooper; Editing by Barbara Lewis)