At 0720 GMT, commercial banks posted the shilling at 85.60/80 against the dollar, up from Monday's close of 86.80/87.00.

Tax payments which are due this week are likely to further squeeze liquidity in the market, helping the shilling head higher as market participants cut their dollar positions, traders said.

"There has been a slow build-up of dollar positions and now that the post-holiday demand has petered out, banks will start cutting those positions," said a senior trader with a leading commercial bank.

Charts showed that with the 50-day moving average at 88.16, the shilling was likely to trade in a range of 85.00-88.20, with a break past 85 ushering in a target of 82.80 per dollar.

Further support for the shilling could come from inflows into government debt auctions, where yields are standing at just over 20 percent, from low-single digits in the year-ago period.

"With the short-term rates looking very attractive and stability of those rates likely to hold for the next two months, foreigners might participate in the debt auctions," said the senior trader.

Bank of Africa said in a regular market report that demand for dollars from energy sector importers could creep back into the market, curbing the shilling's rally.

'However, with the authorities continuing with their tightening stance, the local unit could get support ... any weakness in the local unit could attract intervention," it said.

The central bank has mopped up a total of 24 billion shillings ($275.86 million) through repos and sold an unspecified amount of dollars this month to prevent the shilling from falling steeply.

Policymakers raised rates four times in the last four months of 2011, lifting the shilling its record low of 107 to the dollar, hit in October. Surging import prices as a result of the sharp falls in the shilling had caused an outcry in the nation of 39 million people.