Sterling touched a new 20-month high against the euro on Tuesday, driven by diverging interest rate expectations for Britain and the euro zone, though concerns over economic growth and EU ties kept the currency broadly flat on the day.
Money markets are pricing in a rate hike by the Bank of England at its Nov. 4 meeting, helping the pound rally around 2% versus the euro and the dollar so far this month.
The euro meanwhile is being dogged by signs the European Central Bank (ECB) will be among the last to raise interest rates in the developed world. Monday data showing German business morale deteriorating for the fourth month running in October, cemented expectations of a dovish message from Thursday's ECB meeting.
By 0850 GMT, sterling traded at 84.2 pence to the euro, 0.2% firmer on the day at the highest since February 2020, while against the dollar it was marginally firmer at $1.378, having come off five-week highs touched last week.
However, Britain's weak economic data -- including last Friday's unexpected drop in retail sales -- has capped the pound's gains. Short-dated gilt yields too have slipped from 17-month highs hit last week, with fears growing that impending policy tightening will exacerbate the slowdown.
"Euro-sterling is trading close to the bottom end of its post-referendum low on BoE hike expectations. But UK growth momentum is weakening, which could see euro-sterling turn," Bilal Hafeez, head of the MacroHive consultancy, told clients.
There are also concerns around potential tax hikes that may be unveiled in Wednesday's budget announcement, alongside EU-UK wrangling over provisions that govern post-Brexit trade between Britain, Northern Ireland, and European Union member Ireland.
Britain has threatened to take unilateral action if a solution cannot be found at the ongoing talks, which some reckon could emerge as a serious headwind for the pound.
"Uncertainty around the UK's relationship with the EU may intensify in the coming days and possibly act as a check on BoE rate hike bets next week or at the December meeting, as well as set a short-term floor on euro-sterling," Scotiabank analysts wrote, highlighting levels around 84.20-84.5 pence.
Another headwind for the UK economy could be the surge in sterling's trade-weighted exchange rate, which closed Monday just off the 5-1/2-year highs hit on Friday.
Traders are now awaiting finance minister Rishi Sunak's budget statement on Wednesday, though his plans for higher corporation tax and national insurance contributions alongside more spending are already known.
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