LONDON (Reuters) - Sterling hit a fresh 3-1/2 year high against the euro on Tuesday as market focus switched back to the euro zone debt crisis, spurring the pound to recover from an early dip caused by comments from the Bank of England governor.
The euro dropped 0.4 percent to 79.005 pence, hit by comments from Italy's prime minister and ahead of a German constitutional court ruling that could thwart the deployment of the euro zone's rescue fund.
Italian premier Mario Monti said his country may be interested in tapping euro zone aid funds for bond support reserved for member states that comply with European commitments and that do not require external surveillance.
Sterling had eased earlier after Bank of England chief Mervyn King said the British economy was showing little signs it was about to recover and expressed concern on the export outlook.
But market participants took the opportunity to sell the euro and buy pounds, adding that although the UK economic picture looked bleak, the euro zone outlook was worse.
"I'm negative on sterling versus the dollar, but euro/sterling could head even lower, possibly towards 78.00 in the coming couple months," said John Hardy, FX strategist at Saxo Bank.
The euro was also reeling against major currencies after a late night meeting of euro zone finance ministers on Monday made little progress towards using the bloc's rescue funds to stem soaring Spanish and Italian borrowing costs.
The pound was lower against the dollar, trading down 0.2 percent at $1.5495, edging closer to a one-month low of $1.5461.
Sterling had gained early in the session after better-than-expected UK production figures. But other retail sales and housing data were weak and analysts said the broad picture remained of a fragile UK economy.
"Overall the news from the UK is very negative and sterling is still very vulnerable," said Ian Stannard, head of European FX strategy at Morgan Stanley.
"Any further moves higher in cable (sterling/dollar) will be short-lived and provide renewed selling opportunities," he added.
Looking forward, analysts said the market would scrutinise minutes from last month's meeting of the U.S. Federal Reserve, to be published on Wednesday.
Any indication the Fed may opt for another round of asset buying before the end of the year is likely to weigh on the dollar versus sterling, they said.
Editing by Susan Fenton