LONDON (Reuters) - Sterling rose to a 16-month peak against the euro on Tuesday, after a report showed British inflation rose more than expected in April and helped to widen the gap in yields between UK government and euro zone bonds.
Britain's consumer price index rose to an annual rate of 1.8 percent last month from 1.6 percent in March, according to the Office for National Statistics. Economists in a Reuters poll had expected the index to rise 1.7 percent.
The euro fell 0.35 percent to 81.19 pence, its lowest since early January 2013, from around 81.30 pence before the data were released. The gap between UK two-year gilt yields and euro zone two-year yields widened after the report, helping the pound, traders said.
In contrast with the tick up in British inflation, the pressure of falling prices is pushing the European Central Bank towards looser monetary policy next month. It could also take the deposit rate, the rate at which banks deposit excess funds with the ECB, into negative territory, making it unattractive to buy euros.
"UK inflation is higher than expected and further improvement in labour market conditions mean in coming months the BoE cannot keep rates low for longer. So that is being reflected in sterling's rise," said Manuel Oliveri, FX strategist at Credit Agricole.
Sterling rose against the dollar to a day's high of $1.6870 after the data from around $1.6850 beforehand. It was last trading at $1.6835, still up 0.1 percent on the day.
"The data fuels expectations for an early rate hike from the Bank of England, this despite the dovish tone of the Inflation Report last week," said Alex Edwards, head of corporate desk at UK Forex.
After the inflation data, rate hike expectations received a slight boost. The sterling overnight interbank average (SONIA) curve showed investors pricing in slightly better chance of a rate hike in 10 months' time.
Rate hike expectations were dampened last week after the BoE's quarterly inflation report and accompanying remarks by Governor Carney suggested a rate hike may not happen quite as early as many had anticipated.
The UK economic picture painted by recent data was still brighter than the outlook for the euro zone and the United States, analysts said, making the pound attractive whenever it retreats.
Morgan Stanley analysts have recommended that investors build short positions in the euro against the pound, targeting a drop to 80.50 pence.
Reporting by Anirban Nag; Editing by Larry King