The pound strengthened against the dollar to climb above the $2.04 mark for the first time in more than a quarter of a century yesterday, as currency traders braced themselves for fresh dollar weakness this week.

The greenback fell against currencies such as sterling and the Australian and New Zealand dollars, where interest rates offer higher returns.

The pound rose as high as $2.0405 in morning trading, its highest level in 26 years, before falling back to $2.0366.

Continued weakness in the American housing sector and the possibility of a slowdown in inflation prompted speculation that the US Federal Reserve could move to cut interest rates next year.

By contrast, the Bank of England is expected to raise interest rates once more to 6 per cent, thereby widening the yield gap between the American and British currencies and chipping away further at the dollar’s value against sterling.

The latest update on producer price inflation in the United States will be published today. Tomorrow US consumer price inflation figures will be released and there will be the first of two days of congressional testimony by Ben Bernanke, the Fed Chairman.

Chris Furnace, the head of currency strategy at 4Cast, the consultancy, said that the data would do nothing to stop the dollar sinking further.

“In the very near term, [the pound at $2.04] is not only sustainable, it will be beaten,” he said.

“We’re looking at $2.05 and a bit. Once the trader market gets its teeth on to one of these levels, it takes quite a lot of work to stop it happening.”

Paul Mackel, director of currency strategy at HSBC, said: “There’s still the concern over what’s going on in the sub-prime sector, and whether that will have any knock-on consequences for corporate bonds.”

US government bond prices rose, with the yield on the benchmark ten-year Treasury note dropping to 5.07 per cent, compared with 5.10 per cent on Friday, as sub-prime mortgage assets weakened, underscoring persistent worries about the housing sector.

The benchmark ABX sub-prime mortgage index, used by investors to hedge sub-prime mortgage risks, tumbled to a new record intraday low, as confidence in the loans continued to slide. The euro was little-changed against the dollar, trading just below a record high of $1.3813 reached on Friday.

President Sarkozy appeared to bow to criticism from Germany when he softened his campaign for the European Central Bank (ECB) to try to mitigate the euro’s strength. “France is for the independence of the European Central Bank,” he said, during talks with Angela Merkel, the German Chancellor, in Toulouse. “The problem isn’t the value of the euro but the value of other currencies.”

Analysts expect the ECB to raise interest rates from their present 4 per cent, amid concerns that inflation will accelerate in the coming months.

Steve Barrow, currency strategist at Bear Stearns, said that his call of a euro at $1.45 in a year’s time was “starting to look conservative”.

As the dollar traded lower, the benchmark London Brent crude oil future rose to an 11-month high of $78.40, just 25 cents below the record high that was achieved last August. However, prices fell back later by about a dollar a barrel.

David Moore, at Commonwealth Bank of Australia, said: “The markets will retain focus on North Sea production problems and refinery outages in the week ahead.

“These factors will continue to support prices at the current levels.”

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