LONDON (Reuters) - Sterling retreated further from a recent 16-month high against the dollar on Thursday after UK construction data disappointed and fresh budget wrangling in Washington boosted the more liquid U.S. currency.
The UK construction purchasing managers index (PMI) came in below expectations, falling to its weakest level in six months. That took some of the shine off Wednesday's better-than-expected manufacturing PMI, but most investors were waiting for the more important services sector PMI, due on Friday.
Against the dollar, the pound was down 0.5 percent at $1.6169, off a 16-month peak of $1.6380 hit on Wednesday after the U.S. Congress averted budget cuts that could send the world's biggest economy into recession. The pound was trading at $1.6230 before the UK construction PMI was released.
The euro was down 0.1 percent against the pound on the day at 81.05 pence. Earlier it hit a three-week low of 80.86 pence, which coincided with the 55-day moving average and a key support.
The euro's latest drop took it further away from the eight-month high of 82.25 pence struck last week.
"We are looking for euro/sterling to gradually ease back towards 80 pence," said Richard Driver, currency analyst at Caxton FX. "The UK manufacturing sector data was good but it will be a real surprise if the services sector PMI is that good. Still, over the medium term we prefer sterling over the euro."
Some analysts said they expected the euro zone economy to struggle more than the UK in coming months as tough austerity measures and high unemployment across parts of the currency bloc dampen economic activity.
That could increase pressure on the European Central Bank to cut its deposit rate - the rate at which banks park their excess cash with it - into negative territory when it meets next Thursday. Such a move would weigh on the euro.
"I am looking at euro/sterling at the 80.5 pence level over the next couple of days ... and on the lookout for an opportunity for a short position next week ahead of the ECB meeting," said Steve Barrow, head of G10 currency research at Standard Bank.
The Bank of England also meets next Thursday, but is widely expected to keep rates on hold and its asset purchase programme unchanged until at least March this year.
The disappointing UK construction PMI data was somewhat offset by a Bank report which showed an uptick in credit demand.
Some economists said that if the BoE's Funding for Lending Scheme worked and British bank lending for mortgage and corporate lending rose, there would be less need for the central bank to pursue further quantitative easing in coming months.
That is likely to help the pound against the euro, but uncertainty over U.S. budget cuts could see it struggle against the dollar. Financial market stress and economic uncertainty usually boost the more liquid dollar.
Sterling, along with other currencies, came under pressure against the dollar as some of the euphoria generated from the U.S. budget deal faded with investors bracing for political battles ahead over spending cuts.
Aside from the budget problems in the United States, difficulties facing the UK and the euro zone - Britain's biggest trading partner - are also likely to keep investors wary of the pound.
"With a growth forecast of only 1 percent in 2013 and inflation around 3 percent these are hardly the ingredients for a strong currency," Commerzbank said in a note.
"Hence any significant rally (in sterling) in our view should be seen as a selling opportunity in the short term."
Editing by Susan Fenton