Sterling recovers after steep losses but still vulnerable

The euro was down 0.4 percent at 86.58 pence as it recovered from sharp gains on Friday when it rose more than 1.5 percent to hit 87.17 pence and posted its biggest daily percentage rise since October 2009.

But any weakness in a purchasing managers' survey on UK construction activity due at 0930 GMT could highlight the problems facing the UK economy and the risk of it slipping back into recession, putting the pound back under selling pressure.

"We're seeing a bit of profit-taking in the euro ... Sterling has gone a long way this year and many (market participants holding) euro/sterling longs are minded to take some money off the table," said Michael Derks, chief strategist at FXPro.

But he said the pound remained vulnerable, especially against the dollar "simply because the UK economy is going nowhere and the US economy is looking reasonable". He said sterling could drop to $1.54 within the next 4-6 weeks.

The pound was up 0.1 percent against the dollar at $1.5710 , holding above a 5-1/2 month trough of $1.5674 hit early last week.

Traders also said the euro was weighed down by data showing the Spanish jobless rate rising and by a rise in Spanish borrowing costs.

 Sterling's trade-weighted index stood at 79.9, matching the 14-month low it reached on Friday, Bank of England data showed.

UK construction PMI is expected to have edged up to 49.1 in January from 48.7 in December, though this would still leave the reading below the 50 mark that separates growth from contraction in the sector.

 But key this week will be the PMI survey on the dominant services sector on Tuesday for clues on how the UK economy has fared in early 2013 after the economy contracted by more than expected in the fourth quarter of 2012.

The Bank of England announces its monthly policy decision on Thursday and is expected to leave interest rates and its quantitative easing target unchanged.

Focus will centre on the testimony by BoE Governor-designate Mark Carney before a parliamentary committee later this week, which could knock the pound if he hints he favours further monetary easing to boost a flagging UK economy.

"We expect sterling to remain an underperformer, with sterling/dollar appearing particularly vulnerable. We now expected a sterling/dollar decline to the $1.5400 area, where the euro/sterling 0.8800 area is also now within reach," Morgan Stanley analysts said in a note to clients.