LONDON - Sterling rose to 20-month highs against the euro on Tuesday, driven by diverging interest rate expectations for Britain and the euro zone, especially after data showed UK full-time earnings rising by the most since 2008.
Money markets are pricing in a rate hike by the Bank of England before the end of the year BOEWATCH and expectations of further tightening grew as labour market data showed median full-time weekly pay in April was 4.3% above year-ago levels.
Monday data showing German business morale deteriorating for the fourth month running in October cemented expectations of a dovish message from Thursday's ECB meeting.
By 1100 GMT, sterling traded at 84.08 pence to the euro, 0.3% firmer on the day, just off the 84.04 level that was the highest since February 2020. Against the dollar, it strengthened to $1.382, up 0.4% and approaching five-week highs touched last week.
"Yields have moved sharply in favour of the pound of late though the rally has been mostly against lower-yield currencies like the euro and yen," Lee Hardman, FX strategist at MUFG Securities, said.
While Tuesday's upbeat market mood was also allowing the pound and other higher-beta currencies to strengthen against the dollar, Hardman said the repricing of rate expectations had not benefited the pound as much as might be expected.
"There is an element of caution in chasing the pound higher on the back of higher rates. The combination of slower growth and higher inflation is not a good mix for a currency," he added.
Britain's growth data has been relatively weak, including last Friday's unexpected drop in retail sales, which has pushed short-dated gilt yields off 17-month highs hit last week.
There are also concerns around potential tax hikes that may be unveiled in Wednesday's budget announcement, alongside EU-UK wrangling over provisions that govern post-Brexit trade between Britain, Northern Ireland, and European Union member Ireland.
Britain has threatened to take unilateral action if a solution cannot be found at the ongoing talks, which some reckon could emerge as a serious headwind for the pound.
"Uncertainty around the UK's relationship with the EU may intensify in the coming days and possibly act as a check on BoE rate hike bets next week or at the December meeting, as well as set a short-term floor on euro-sterling," Scotiabank analysts wrote.
Another headwind for the UK economy could be the surge in sterling's trade-weighted exchange rate, which closed Monday just off the 5-1/2-year highs hit on Friday.
Traders are now awaiting finance minister Rishi Sunak's budget statement on Wednesday, though his plans for higher corporate tax and national insurance contributions alongside more spending are already known.
(Reporting by Sujata Rao; Editing by Emelia Sithole-Matarise) ((firstname.lastname@example.org ; +44 207 542 6176/020 7536 7473/44 7990567646))