LONDON: Sterling gained ground on Thursday but failed to hold onto 17-month highs hit against the euro after a European Central Bank meeting that did little to dent the single currency's immediate appeal.
Expectations that the Bank of England will raise interest rates next year have driven the pound 10 percent higher against a basket of currencies over the past year.
That move has stalled in recent months but, all things being equal, the ECB's moves on Thursday to cut returns on the euro into negative territory should have benefited the pound more than, for example, the dollar and yen.
Instead, after an initial jump, sterling was just 0.16 percent higher against the euro on the day while British government bonds were broadly unchanged in relation to German Bunds - though they did end a four-day losing streak.
"Despite all the noise from the ECB, we are still roughly in the same place we were before today: if they want to persistently weaken the euro from here, they need to announce a QE-style programme," said Stephen Gallo, a strategist with Canadian bank BMO in London.
"European bond yields have held up pretty well here, despite the (ECB's) depo rate cut, so we still are going to need to see significantly higher rates outside of Europe first, before we can see that divergence really widen out further."
Sterling was a third of a percent higher against the dollar , benefiting from the fallout of the euro's bounce back from intraday lows versus the greenback.
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Still, that outlook for higher official UK borrowing costs next year has opened up premium of more than 60 basis points between British and German two-year debt. Over five years it is around 150 basis points.
The two-year yield spread narrowed by 3 basis points, but spreads for longer maturities were little changed as traders struggled to digest the implications of the ECB's rate cuts and other liquidity measures to boost the euro zone economy.
Short-dated gilts were the strongest performers on the day, with two-year yields down 4 basis points at 0.68 percent by 1528 GMT, and at one point as low as 0.667 percent.
"We've followed Bunds around," said Nomura strategist Andy Chaytor. "Some more volatility is going to be required before the market settles down and decides what it thinks about this package."
Ten-year gilt yields finished 2 basis points down on the day at 2.68 percent as prices edged up, breaking a four-day run of price falls despite yields earlier hitting a fresh three-week high of 2.727 percent.
Ten-year gilts' yield spread over Bunds was particularly choppy, briefly touching a two-week high of 128.8 basis points before finishing little changed at 125 basis points.
Chaytor said the moves reflected market volatility rather than any underlying shifts in the outlook for British monetary policy.
The Bank of England kept interest rates steady at 0.5 percent on Thursday, as expected, and Chaytor said wage inflation data next week and policy minutes the week after were the only scheduled events likely to shift markets' view.
Paul Robson, a strategist with RBS in London, said UK data and the outlook for euro zone policy continued to support the pound, no matter what action the ECB took.
The latest survey of a housing market that has been one of the big drivers of British growth in the past year showed prices jumped almost 4 percent on the month in May.
"We've had some strong numbers in the past week and there is further evidence the housing market is still strong," Robson said. "The euro area is also recovering but it is doing so at a slower pace. The short-term focus for markets should be yields and yields will be moving in favour of sterling."
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