LONDON (Reuters) - Sterling rose to a five-week high against a struggling euro on Monday as a bailout plan for Cyprus that included a tax on bank deposits was seen as setting a dangerous precedent that could spark bank runs elsewhere.
The euro slid more than 1 percent to around 85.32 pence, its lowest since February 11, taking it well below a peak of 87.93 pence reached last week. It then pared losses to last trade down 1 percent at 85.58 pence.
But sterling's gains were expected to be limited before Wednesday's UK budget and the latest Bank of England minutes, with investors wary the government may allow more leeway on inflation targeting, paving the way for further monetary easing.
"Today it's all about Cyprus, and the market's reaction speaks for itself. They have laid dangerous foundations and it puts Britain's austerity problems into perspective," said Nawaz Ali, market analyst at Western Union Business Solutions.
"But euro/sterling is delicately poised. Sterling will be in danger if the budget and the minutes leave investors in no doubt that monetary easing will be taken to another level later this year."
In a radical departure from previous aid packages, euro zone finance ministers demanded bank depositors in Cyprus pay up to 9.9 percent of their deposits in exchange for the bailout.
Officials in Cyprus have suggested they will look at ways of ensuring that smaller depositors are not hit. Cyprus's parliament has postponed a vote on the plan until Tuesday.
Gains against the euro helped push sterling's trade-weighted index to 79.5, its highest in nearly four weeks, bank data showed.
Against the dollar, sterling was steady at $1.5120, below a peak of $1.5177 reached on Friday after Bank of England chief Mervyn King surprised investors by saying the currency's decline had gone far enough.
King's comments helped the pound recover from a 33-month low of $1.4832 set earlier last week. However, traders said a reportedly very large options expiry at $1.5100 due on Monday could keep it trading close to that level.
The bank's policymaker Ian McCafferty backed up King's comments on Monday, saying in an interview that the inflationary impact of a rapid fall in sterling would be "damaging for the UK economy". However, he also said the central bank stood ready to support a UK recovery.
Westpac analysts said in a note to clients that they remained short on the euro against both sterling and the dollar due to concerns the Cyprus deal could spark a "period of instability in financial markets".
But Morgan Stanley analysts said the pound may not benefit as much from safe-haven flows out of the euro as it has in the past, with investors more likely to turn to the U.S. dollar and currencies like the Australian and Canadian dollars.
"The BoE moving the goal posts on its inflation target, the relative weakness of the British economy and the UK's poor fiscal position should limit sterling gains too."
They cut their forecasts for sterling/dollar and now see it dropping to $1.43 by the end of 2013. Due to the Cyprus situation they said it may rise near-term but they would use any rebound towards $1.5340/$1.5400 to re-establish bearish strategies.