Sterling recovered on Wednesday, though it remained vulnerable as traders weighed the benefit of government support to shield the economy from the COVID-19 pandemic against the high financial costs of doing so.
The pound rose in spite of the fact that Britain's economy shrank by a record 5.8% in March as the coronavirus crisis escalated and the government shut down much of the country.
Analysts attributed the move to previous market expectations and to the short positions in sterling held by global leveraged funds.
Even though the fall in the U.K.'s gross domestic product was severe, the decline was not as bad as feared by the economists polled by Reuters, who were expecting the economy to shrink by 8%.
Moreover, the fact that market participants held nearly $1 billion in sterling shorts meant that any small enthusiasm had a bigger effect on the British currency, said Kit Juckes, macro strategist at Societe Generale.
"Nobody runs in to take the other side of these moves ever at the moment," Juckes said.
Another reason behind the sterling upswing was a broad-based weaker dollar in anticipation of what Federal Reserve Chairman Jerome Powell might say about monetary policy later in the day, Juckes said.
Sterling was last trading up 0.4% at $1.2310. It was last up 0.2% versus the euro at 88.36 pence.
Britain on Tuesday extended its job retention scheme, in which the government pays 80% of furloughed workers' wages, by another four months until the end of October. But analysts estimate it will cost the government billions to fund this scheme, which will then likely lead to higher debt and taxes.
Ministers will have to raise taxes sharply in the coming months to deal with an estimated 337-billion-pound deficit in the current financial year, according to a leaked Treasury document, the Financial Times reported on Wednesday.
"While the additional support for employment is welcome, the cost could quickly start to weigh on investor sentiment especially if second COVID waves emerge going forward," said Derek Halpenny, head of research at MUFG.
The scheme is estimated to cost 49 billion pounds ($60 billion) through to June, and an additional 30 billion pounds to run it through October, he added.
The pound has lost 2.5% of its value against the dollar so far this month, making it the biggest underperformer among the major currencies. However, the pound was far off its March lows, when it sank to $1.14, its lowest in decades. ($1 = 0.8149 pounds)