LONDON - Sterling rose to a three-week high against the euro on Tuesday, recovering from a sharp selloff last week as traders turn their attention back to the prospect of interest rate rises in Britain.
Rising inflation expectations hit risk sentiment last week and saw bond yields climb higher, pushing risk-sensitive sterling to a two-month low versus the euro and to its lowest level against the dollar since December 2020.
But by 0825 GMT, sterling was 0.2% higher against the euro at 85.22 pence, after jumping back to its highest level since mid-September.
Sterling's recovery "seems surprising", said Ulrich Leuchtmann, head of FX and commodity research at Commerzbank.
While the European Central Bank has no plans to raise rates soon, the prospect of imminent rate hikes, signalled by the Bank of England, is lending support to the pound again, Leuchtmann said in a note to clients.
"In view of the significant discrepancy between ECB and BoE comments, one should expect sterling to be stronger," he said.
The pound has gained almost 5% versus the euro this year, but caution should prevail, said Leuchtmann.
He said it was unclear whether the BoE might "cave" in the face of the supply problems and abandon the idea of more rapid rate hikes.
Britain's supply chains for everything from pork, petrol and poultry to medicines and milk have been strained by shortages of labour since Brexit and the start of the COVID-19 pandemic.
Analysts flagged that the pound looked not to have reacted to renewed Brexit risk after Britain told the European Union on Monday it would trigger safeguard measures in their divorce deal if the bloc failed to agree to changes to smooth trade with Northern Ireland.
European states have promised they will within days announce measures to apply pressure on London to abide by Brexit agreements.
Versus the dollar, sterling was 0.1% higher at $1.3620, not far from the week's high, touched the previous day.
(Editing by Timothy Heritage) ((Joice.Alves@thomsonreuters.com, Twitter @joiceal))