Sterling is set for its worst month since late 2016 against the dollar and its worst versus the euro since mid-2021 as fears the British economy is slowing sharply just as inflation gathers pace has sent investors rushing to sell the currency.

The pound was down 4.4% for the month of August and was last trading at $1.1645, which would eclipse a loss of 4.3% in April.

On Monday sterling fell to its weakest since March 2020, when panic about the spread of Covid-19 hit markets.

Despite a small rebound yesterday to 85.82 pence against the euro, the British currency has shed 2.2%, putting it on course for its weakest month since April 2021.

The weakness against the euro, which has been battered by concerns about shortages and soaring prices of natural gas, underlines how widespread market jitters are about Britain.

Inflation is at 10% and predicted to climb higher, squeezing the pay packages of hard-hit consumers further. British government bonds are on course for their biggest monthly fall since 1994 as investors dump gilts.

Scotiabank's chief FX strategist, Shaun Osborne, said money markets now point towards the Bank of England raising interest rates to 4.25% next year, up from a current 1.75%.

"This would leave the Bank of England policy rate among the highest of the major economies but that may still not compensate investors sufficiently for inflation that is expected to run well into double digits early next year while the economy tilts into recession," he said.

"Beyond the stagflation risk, the GBP will not react well to renewed equity market weakness as central banks persist with interest rate increases...while the domestic political backdrop remains unhelpful," he added, pointing to downside risks for the pound of $1.10 and 90 pence per euro in the next few months.

UBS Global Wealth Management today said it was forecasting a sterling/dollar rate of $1.12 by year-end, with a more hawkish Federal Reserve driving up the dollar.

Adding to nervousness around the pound is the election of a new Conservative Party leader and prime minister.

The winner will be announced on Monday, and some economists are concerned that the hefty tax cuts pledged by frontrunner Liz Truss could put more pressure on public finances just as the cost of servicing government debt grows.

"The new leadership is likely to unveil a sizable fiscal boost for the economy to lower the tax burden and provide help for households. That may provide some brief respite for the GBP but a significant rebound in the GBP looks a distant prospect at this point and minor gains in the next few weeks are liable to attract renewed selling pressure," Scotiabank's Osborne said.