LONDON: Sterling held near a 16-month high versus the euro on Wednesday and was expected to remain supported due to the euro zone debt crisis, but the pound neared a three-month low against the dollar on waning risk appetite.
On Monday the pound hit its highest against the euro since September 2010, climbing to 82.22 pence, and was trading flat for the day on Wednesday at 82.51, but analysts said the outlook was skewed in sterling's favour, despite the fragility of the British economy.
"Sterling is possibly the strongest of the European currencies as it is perceived as a safe haven. The UK government's fiscal plan is viewed as far more credible and gilts' safe-haven status suggests sterling will benefit to some extent," said Raghav Subbarao, currency strategist at Barclays Capital, whose 12-month forecast for euro/sterling is 80 pence.
British government bond yields have slumped to record lows in recent months, as prices surged on the back of a second round of quantitative easing asset purchases from the Bank of England and safe-haven flows from investors worried about the euro zone.
The euro and risk appetite were knocked on Wednesday after Fitch ratings said the European Central Bank needed to do more to support Italy's sovereign bonds.
Key tests of investor sentiment such as forthcoming Italian and Spanish debt sales and the European Central Bank's monetary policy decision were keeping investors on edge.
"Over the medium term we continue to think that EUR-GBP should move lower and we view the August 2010 low of 81.47 as an initial take profit level for short EUR-GBP positions," said analysts at Commerzbank in a note.
Traders reported stop-losses around 82.90 which they said could be hit if short euro positions were squeezed further, but offers were then highlighted at 83.10/30.
Sterling was trading down 0.6 percent on the day versus the dollar at $1.5386 after traders said a US bank sold it through stop-losses under $1.5450. It later found support around a three-month trendline at $1.5374 with the December low just underneath at $1.5361.
Traders reported demand placed around $1.5350, with a break below there opening up the 2011 low hit in October of $1.5270.
"We definitely think cable will move lower and to some extent that will be driven by the euro area issue which we expect will cause all European currencies to weaken," said Subbarao, who added Barclays' forecast was for a fall to $1.50 in twelve months.
Focus will switch back to the UK on Thursday when the Bank of England announces its latest decision on monetary policy but no changes in interest rates from record lows is expected and any increase in its asset purchase programme is more likely in February.
The UK trade balance widened more than expected in November, data showed in Wednesday, while separately British shop prices grew at their slowest pace in 16 months in December as retailers slashed prices for electrical goods, clothes and footwear in the run-up to Christmas.
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