Sterling jumped on Tuesday after a survey showed companies in Britain's dominant services sector grew more quickly than expected in May after a winter slump in early 2018. But the mood concerning the pound's outlook remained more subdued due to uncertainty surrounding Britain's planned exit from the European Union in March 2019 and the Bank of England's path for monetary tightening.
After slumping 3.43 percent against a resurgent dollar in May, sterling started June on the front foot, buoyed by data showing signs of a possible strengthening of the British economy after a sluggish first quarter.
The IHS Markit/CIPS services purchasing managers' index (PMI) rose to a three-month high in May, better than forecast in a Reuters poll of economists.
That pushed sterling up to $1.3391 - close to a two-week high - before it tapered later in the session to $1.3339 as the dollar strengthened broadly.
Against the euro, the pound also rose to a four-day high of 87.25 pence.
Tuesday's business survey - the third in as many days to show tentative signs of strength returning to the economy - could increase the chances of a Bank of England interest rate hike later this year.
Investors are now pricing in a roughly 40 percent chance of the BoE raising borrowing costs in August - the next time it updates its economic forecasts.
But analysts warned that risks around the sort of relationship Britain can agree with the EU after Brexit continue to cloud the currency's outlook.
"Brexit concerns and uncertainties still hang over these [rate hike] expectations and these concerns will only develop over the summer," said Hamish Muress, currency analyst at OFX.
Analysts at Barclays said that business conditions in Britain were less favourable today than three months ago.
"The May rebound confirms some weather-related weakness in early 2018 it also shows that the underlying trend of economic growth is weak in the first half of 2018," the analysts said in a note to clients. Bad weather and slow growth saw markets in May drastically scale back expectations for monetary tightening.
BoE interest-rate setter Silvana Tenreyro said on Monday much of the weakness in Britain's economy in early 2018 would probably prove temporary but that the timing for any rate rise was an open question. "While I anticipate that a few rate rises will be needed, the timing of those rate rises is an open question," she said.
With time running out for Britain to secure a deal before exiting the European Union, diplomats are hoping an EU summit on June 28-29 can break a deadlock over the terms.
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