LONDON (Reuters) - Sterling recovered from a 2-1/2 year low against the dollar and gained against a weaker euro on Wednesday as some investors believed its recent steep falls may have gone too far for now.
A faltering domestic economy, however, was expected to leave the British pound vulnerable to further falls ahead of the UK budget on March 20.
The pound was up 0.1 percent against the dollar at $1.4917 (9993 pence), off a low of $1.4832 (9936 pence) hit on Tuesday after data showed UK manufacturing output contracted sharply in January.
The euro fell 0.8 percent to 86.74 pence, retreating from a more than two-week high of 87.93 pence hit on Tuesday. It came under pressure after an Italian government debt auction drew weaker demand, causing Italian borrowing costs to rise.
Analysts said the pound's gains were also the result of investors who had sold it at higher levels seeing an opportunity to take profit, particularly given a lack of UK data for the rest of this week.
"In terms of positioning it is quite short sterling... you can get short squeezes, you had that ahead of the last Bank of England meeting so you could get that going forward (ahead of the March 20 budget), but is unlikely to be huge," said Saeed Amen, currency analyst at Nomura.
Amen said sterling could fall 2-3 percent against the dollar in the next few weeks.
Strong U.S. retail sales boosted the dollar against both the pound and the euro, with some analysts pointing to the data as contributing factor in the euro's losses versus sterling.
Sterling has been one of the worst performing currencies of 2013 and has lost more than 8 percent against the dollar and around 7 percent against the euro so far.
But any gains were expected to be limited. Tuesday's weak UK data raised the prospect of the economy slipping into another recession and increased the chances of the Bank of England extending bond purchases under its quantitative easing programme.
Central bank asset purchases increase the supply of a currency and drive down its value.
"When any currency falls too fast too quickly there is always going to be a correction. But fundamentals still point towards further sterling weakness," said Nawaz Ali, market analyst at Western Union Business Solutions.
Analysts said any short-covering rally in the pound may be curtailed when Chancellor George Osborne presents his budget on March 20.
Traders speculate that Osborne will announce a review of the BoE's remit and give it more leeway on inflation targeting, allowing scope for a further easing of monetary policy.
Additional reporting by Jessica Mortimer; Editing by Toby Chopra