LONDON: Sterling edged towards a two-year high against the euro on Tuesday as hedge funds and speculators sold the single currency against the dollar and pound, betting euro zone monetary policy would stay loose.
The risk of a surprise in September's referendum on independence for Scotland kept two-month sterling/dollar implied volatility close to Monday's five-week highs.
While recent UK economic data has been mixed, June inflation was a higher-than-expected 1.9 percent, just shy of the Bank of England's 2 percent target, bolstering expectations that the BoE will hike interest rates in the coming months.
In contrast, in the euro zone, where the benchmark interest rate was slashed to 0.25 percent in June, the European Central Bank has left open the possibility of further monetary loosening - possibly through quantitative easing (QE).
Data on Tuesday showing Britain's public finances with a bigger-than-expected deficit in June had little impact on sterling.
More important, traders said, would be inflation data later on Tuesday from the United States, where the dollar has been boosted by a run of robust data as well as a slightly less dovish tone from Federal Reserve Chair Janet Yellen.
The dollar index hit a six-week high on Tuesday, buoyed by its gains against the euro as speculators bet on robust U.S. inflation, in contrast with the very low price growth in the euro zone.
"Focus is shifting at the moment to dollar," said Neil Mellor, a currency strategist at the Bank of New York Mellon. "For a little while now there has been this sense that the dollar is stabilising and is about to soar, and that has taken the shine off currencies like sterling for the time being."
Sterling edged down to $1.7066, over a cent lower than last week's near six-year high. The euro weakened by quarter of a percent to 79.005 pence, close to a two-year low.
Traders are waiting for the main event of the week for sterling on Wednesday - minutes from this month's meeting of the Bank of England's Monetary Policy Committee (MPC) - for any signs of when a first increase in interest rates in seven years might come.
The committee's nine members have so far all voted unanimously to keep the benchmark interest rate at its record low of 0.5 percent.
"MPC discussions will be scrutinised for hawkish signals amid signs of diminishing slack in the economy and our economists do not rule out a split vote at the meeting," said BNP Paribas analysts in a research note. "A hawkish dissent would help push the euro back below 79 pence," they added.
SCOTTISH SURPRISE
Sterling investors face the uncertainty of a referendum on independence for Scotland and on Monday showed a flicker of caution over the risks a surprise from the Sept. 18 vote, driving two-month sterling volatilities to a five-week high of 5.2.
The options, which capture the vote and the results and show how sharp any swing in the currency is likely to be, edged down to 5.13 - still the second-highest in the last five weeks.
Opinion polls still show more than 50 percent of Scots wanting to remain in the UK - far more than the third who want independence - but the gap between the expected "yes" and "no" votes has started to narrow in recent surveys.
"The market is still, even on that basis, looking at one of the quietest periods in financial history over the next two months," said Mellor. "It should be higher - clearly (implied volatility) is not properly reflecting the referendum risks, or any risks in my mind."
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