Sterling hit as UK back in recession, Fed may support

(Adds UK CBI data, trade recommendation)

* Sterling drops after UK unexpectedly enters recession

* Pound retreats from 7-1/2 month high vs dollar

* Euro/sterling off Tuesday's 20-month lows

By Anirban Nag

LONDON, April 25 (Reuters) - Sterling retreated from a 7-1/2 month high against the dollar and fell against the euro on Wednesday after data showed the UK economy had slid back into recession, keeping alive the chances of more monetary stimulus from the Bank of England.

But losses were likely to be limited, with a few sovereign investors buying the pound on dips given a worrying economic outlook in the neighbouring euro zone and expectations that U.S. Federal Reserve chief Ben Bernanke will strike a dovish tone when he speaks later.

Official data released on Wednesday showed Britain's economy slipping back into recession as output contracted by 0.2 percent in the first three months of this year.

Sterling was trading softer at $1.6104, having dropped to a session low of $1.6082 from around $1.6142 before the data was released and well below a 7-1/2 month high of $1.6172 struck earlier in the day. Traders cited sell-stops below $1.6080 and bids under $1.6175

The euro rose to a session high of 82.22 pence from around 81.87 pence before the data release, with traders saying offers above 82.20 pence were likely to check gains.

"The pound had an immediate knee-jerk lurch lower after the GDP release. Since the pound's recent strength was fuelled by expectations of a hawkish BOE, the disappointing Q1 growth data could weigh on the pound fairly heavily," said Kathleen Brooks, research director at UK EMEA at Forex.com.

The central bank's stimulus program tends to be negative for the currency as it involves flooding the economy with billions of pounds of newly-created money.

The pound hit a 20-month high against the euro of 81.435 and a 2-1/2 year peak on a trade-weighted basket of currencies on Tuesday on nascent signs of a pick up in demand in the UK economy and as investors priced out the likelihood of more quantitative easing by the BoE.

Indeed, a survey from the Confederation of British Industry on Wednesday showed factory orders growth remained steady in April. However, quarterly business situation balance rose to +22 in April from -25 in January.

Jane Foley, senior currency strategist at Rabobank said that having made those strong gains, sterling was vulnerable to a sell-off on the back of weaker-than-expected GDP numbers.

"But with other central banks like the Fed and the Bank of Japan still dovish, we could see support for sterling emerge at lower levels."

FED FOCUS

The focus will now be on the conclusion of the Federal Open Market Committee's two-day meeting. The Fed is expected to raise its growth forecasts for the U.S. economy, but Chairman Ben Bernanke is unlikely to signal a tightening of U.S. monetary policy at his press conference given unemployment remains stubbornly high.

The Bank of Japan is also likely to expand its asset purchase programme later this week, while expectations are that the European Central Bank will keep monetary policy loose given the threat of recession in the euro zone.

All of which mean longer-term investors are likely to pick up a more attractive sterling, given BoE policymakers have been flagging inflation risks and a less dovish bias.

Sterling will also be buoyed by safe-haven inflows into UK gilts as political uncertainty and growing worries about the outlook for euro zone peripheral countries sour sentiment towards the euro. As a result, many see sterling rising to 80 pence per euro in the coming months.

The GDP data, though, sparked some profit taking in bearish euro positions against the British pound.

"An unexpectedly weak UK GDP report for Q1 has tempered expectations the economy will outperform," said Ned Rumpeltin, head of G-10 FX strategy at Standard Chartered. "We are taking profit on our short euro/sterling short position."

"Fundamentals still imply further medium-term declines, however; we will look to re-enter at better levels." (Reporting by Anirban Nag; Editing by Toby Chopra)