Sterling rallied to an eight-week high against the dollar and jumped versus the euro on Monday on speculation that rising inflation could prompt the Bank of England to raise interest rates, possibly as soon as May.
The pound also benefited against a broadly faltering euro, which suffered as last week's short-covering rally lost steam and investors sought clearer signs that progress was being made to improve the euro zone's sovereign safety net.
Investors awaited data on UK consumer prices due on Tuesday, which are expected to give more evidence of high inflation. The consensus is for a 3.3 per cent year-on-year rise in December -- far higher than the BoE's 2 per cent target.
A strong reading would put pressure on the BoE to discuss raising rates from a record low 0.5 per cent, although a premature rise could hamper Britain's fragile economic recovery as the government's austerity measures take effect.
"There is a perception that the BoE will probably be forced into raising interest rates before the European Central Bank and the pound is likely to continue to gain against the euro," said Michael Hewson, analyst at CMC Markets.
"If CPI comes in above expectations tomorrow then it is likely to send sterling higher, but there has been an element of pre-buying ahead of the data."
Sterling rose as high as $1.5955, its strongest since Nov. 23, climbing above $1.5935, the 61.8 per cent Fibonacci retracement of the pound's stumble in November-December, which could pave the way for a test of $1.60. By 1605 GMT it had edged back to $1.5908, up 0.3 per cent on the day.
The euro fell a full percentage point to 83.50 pence, pulling back from a rise to near 85 pence on Friday. Traders said bids were rumoured at 83.50 and 83.40 pence.
CMC's Hewson expects the single currency to test its June 2010 low of 80.67 pence, although he said sterling could face some resistance in the near term with its trade-weighted index =GBP near key levels.
Trade-weighted sterling rose as high as 81.7, just shy of the December high of 81.8. Above there would be the highest since September 2010.
RATE HIKE EXPECTATIONS
Expectations have been growing that consistently above-target inflation will force the BoE to raise rates sooner rather than later in order to maintain its credibility. This view was bolstered by Friday's strong UK producer price data. "Short sterling (interest rate futures) have sold off as inflation pressures have been building and people are anticipating that price pressures will continue with CPI tomorrow," said Jeremy Stretch, currency analyst at CIBC.
Escalating rate rise speculation has stung short sterling rate futures, which have sold off since the start of the year. The June contract FSSM1 hit a five-month low last week, almost fully pricing in a quarter-point rate rise by that time.
Market participants said sterling had rallied on the back of demand from a broad range of investors, with talk of buying on Monday by Russian names and a UK clearer. One London trader said he planned to build long positions on any fall to $1.5800.
Highlighting growing demand for the pound, speculators cut net short positions last week according to the latest data from the Commodity Futures Trading Commission. This suggests a dwindling number are betting against the UK currency.
Still, some analysts warn spending cuts may stifle growth.
"The implementation of fiscal consolidation and the escalating euro zone sovereign debt crisis provide material downside risks to growth especially through H1 2011," BTM UFJ analysts said in a note