LONDON Sterling rose on Thursday and was on track for its first quarterly gain against the dollar for almost two years as analysts bring forward their expectations of a UK interest rate rise.
The pound hit an eight-week high of $1.2615 this week and was not far off that high at about $1.25 on Thursday.
It is up about 3 percent in the past two weeks as accelerating inflation fuels expectations that the Bank of England is moving towards tightening policy, and is also benefiting from broad dollar weakness.
Still, traders and strategists said the main driver for sterling in the coming months would continue to be Britain's negotiations with the European Union as it exits the bloc - how those talks play out, and what the economic fallout will be.
Sterling had seesawed on Wednesday as Brexit was formally triggered by British Prime Minister Theresa May, ending the day a little lower.
"The first test for markets is likely to come at the end of April when the EU will hold its first summit on Brexit. This is when the markets will hopefully gauge the tone of the negotiations and whether or not the EU wants to work with the UK to get a decent deal in the bag," City Index strategists wrote in a research note.
"The UK’s economic resilience has been one of the sweet spots post Brexit (and) if this confidence starts to evaporate then it is hard to see how UK asset prices can continue to rally," they said.
For the quarter, the pound is up just over 1 percent against the dollar, having fallen in every quarter since the second quarter of 2015.
But many still see sterling as vulnerable, with the most recent data showing bets against the pound have reached a record high. [IMM/FX]
May has said Britain would like to pursue an ambitious free trade agreement with the EU once it leaves, but EU leaders including Angela Merkel have said Britain can negotiate its new relationship with the bloc only after it untangles its existing EU commitments.
The pound has also been sensitive recently to British economic data, which has started showing mixed signs. Talk of a Scottish referendum - which threatens a break up of the United Kingdom - has also seen investors sell sterling.
Against a broadly weaker euro, sterling climbed almost 1 percent on Thursday to 85.765 pence.
"With actual negotiations with the EU not starting ahead of May/June, and as the BoE continues to link its policy stance to long-term uncertainty, we believe rate expectations and the pound will remain capped," Credit Agricole strategists wrote in a note to clients.
(Editing by Louise Ireland)