REFILE-Sterling hits 3-1/2-year high against sliding euro

Fri Jul 13, 2012 7:18pm BST

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(Inserts dropped word 'year' in headline, lead paragraph)

* Euro broadly lower after Moody's cuts Italy credit rating

* Pound up 0.8 pct vs dollar but remains at risk

* UK inflation, retail sales data to come next week

By Michael Szabo

LONDON, July 13 (Reuters) - Sterling rose to a 3-1/2-year high against a broadly lower euro on Friday after Moody's downgraded Italy and investors sold Europe's common currency in favour of perceived safer alternatives.

The euro fell as low as 78.63 pence against the pound , its weakest since November 2008. It was last at 78.74 pence, down 0.4 percent on the day.

"The price action suggests this isn't a sterling move but rather a broader euro move," said Adam Myers, senior FX strategist at Credit Agricole.

Market participants continue to shun the euro due to the currency bloc's unresolved debt crisis and slowing global growth.

Moody's cut Italy's credit rating by two notches to Baa2 late on Thursday and warned that further cuts could be on the cards if Italy's access to debt markets dried up.

But the country passed a key market test hours after the downgrade, selling the planned amount in bonds at an auction on Friday that pushed the country's three-year borrowing costs well below 5 percent.

RISES VS DOLLAR BUT VULNERABLE

Sterling rose against the dollar as firmer equity markets encouraged investors to buy riskier currencies.

But analysts said sterling would be vulnerable against the dollar if worries grow about the euro zone or the global growth outlook, making investors more averse to taking on risk.

"If the euro falls, we think cable (sterling/dollar) goes down with it," Myers said.

"Over the next six months euro/sterling is going to continue to fall slowly in the absence of a euro zone break-up, but cable is going to fall also, possibly down through $1.52."

Sterling was up 0.8 percent to $1.5541 against the dollar, nearing a high of $1.5578 hit earlier this week.

"We recommend selling any sterling/dollar rebounds as we believe that sterling will also remain vulnerable to the deteriorating global risk environment," Morgan Stanley analysts said in a note to clients.

Worries about the UK economy could also weigh on the currency. UK data on Friday showed construction output dropped 6.3 percent year-on-year in May, adding to concerns Britain may have contracted for a third consecutive quarter between April-June.

Renewed falls could see sterling retest a five-week low of $1.5393 hit on Thursday.

The UK will publish inflation, jobs and retail sales data next week.

"All this data would be quite important ... but it's going to be secondary to the events taking place in the U.S. and Germany," Myers said.

U.S. Federal Reserve Chairman Ben Bernanke will deliver a semiannual monetary policy report next week that may shed light on whether policymakers will opt for more quantitative easing.

In Germany, parliament will consider Spain's request for up to 100 billion euros in loans from the euro zone's bailout funds for its ailing banking sector.

Sterling was little moved by a new 80 billion pound 'funding for lending' scheme announced by the Bank of England and UK Treasury on Friday, which they hope will help lift the economy out of recession. [ID: nL9E8HQ00H] (Reporting by Michael Szabo; Editing by Ruth Pitchford)

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