LONDON: Sterling held above recent lows against the dollar and cut losses against the euro on Wednesday, drawing support from the Bank of England's latest inflation report which dampened expectations of further monetary stimulus.
But gains looked vulnerable as BoE Governor Mervyn King said there were downside risks to a UK economic recovery given the tight fiscal conditions at home and weakness in Britain's major trading partners.
The BOE raised its two-year inflation forecast to around 1.8 percent, higher than what most economists had expected.
The lower inflation expectations had been keeping alive prospects of it injecting further funds into the economy through its bond-buying program, known as quantitative easing. More QE usually has an adverse impact on the currency.
"That upward revision in inflation forecast has lent some support to sterling," said Richard Driver, currency strategist at Caxton FX. "But after failing to hold convincingly above $1.58 earlier this week, we expect cable to fade lower."
Sterling was last up 0.1 percent against the dollar at $1.5695, rising to $1.5704 from $1.5685 after the BOE report was released. The pound had dropped to $1.5644 on Tuesday, its lowest level since Jan. 27, after Moody's put UK's prized triple-A credit rating on review.
Traders cited offers at $1.5750 and $1.5770 with option expiries at $1.5800.
Against the euro, sterling cut losses made earlier in the session. It was last trading at 83.81 pence, dropping from 84 pence before the report was released. Traders cited stops above 84.10 pence, with bids at 83.50/60 pence.
The common currency was broadly supported by comments from China's central bank governor who said the country would continue to invest in euro zone debt and that it remained confident on the single currency.
Hopes remain that a deal to stave off a Greek default will be struck although many were wary given a string of delays.
Audrey Childe-Freeman, EMEA head of currency strategy at JP Morgan Private Bank said she expected sterling to trade above $1.56 against the dollar in the near term as long as the euro holds above $1.3070.
EXPOSURE TO EURO ZONE
Analysts said given UK's high exposure and strong trade links to the euro zone, sterling's gains would be muted against the dollar and as such many remain bearish about its prospects in the months ahead.
They also expect austerity measures to hurt the UK economy which would derail deficit reduction, raising prospects of a downgrade of its AAA rating.
"Although superficially the UK is better placed than euro zone countries, it is far from immune to contractionary economic forces," said Alan Wilde, head of fixed income and currency at Baring Asset Management.
He said the UK's status as a safe haven looked "increasingly questionable", leaving gilts and sterling potentially at risk.
Westpac's Sean Callow said growth prospects in the UK are unlikely to improve and as such the BOE may not raise its bank rate any sooner than the Fed lifts its funds rate.
He expected sterling to fall against the higher-yielding Australian dollar in the month ahead to A$1.45 from around A$1.4600.
A UK unemployment report released on Wednesday showed that while the number of Britons out of work inched down, the number of those claiming benefit rose by 6,900 in January to 1.604 million--the highest level since January 2010. That was a grim reminder of the headwinds facing the UK economy.
That followed a report showing UK consumer price inflation falling sharply to 3.6 percent in January. However, analysts warned the drop was partly due to last year's VAT rise falling out of the index, and inflation could be stickier later in the year.
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