* Sterling rebounds from session lows on rate outlook
* Markets pricing in 85 pct chance of May hike
* Support for sterling at $1.6014, inflation report awaited
(Adds quote, updates prices)
By Anirban Nag
LONDON, Feb 10 (Reuters) - Sterling recovered on Thursday from a session low against the dollar hit after the Bank of England kept interest rates on hold, on strong expectations that high inflation will force a policy tightening by mid-year.
Traders said speculators liquidated some long positions they had built in the last few weeks but sterling found solid support, with central banks and leveraged accounts cited as buyers at lower levels.
Sterling GBP=D4 was at $1.6052, having fallen to a session low of $1.6011 soon after the BoE announcement. Chartists say there is support at $1.6014, which is the 50 percent retracement of its move from a low of $1.5750 on Jan. 25 to its recent three-month high of $1.6279 on Feb. 3.
The BoE had been widely expected to keep rates at 0.5 percent, but markets had priced in a 20 percent chance of a rate rise. Traders said the hawks who were expecting that had cut their positions, leading to a brief dip in sterling.
“The money markets were pricing in a 20 percent chance of a hike, but no one really expected the BoE to go,” said Chris Turner, head of FX strategy at ING.
“The inflation report from the BoE is due next Wednesday and we expect them to be pretty hawkish there. So sterling will be supported by expectations of interest rate hikes. We see it at $1.70 by the end of the summer.”
A rate hike is being largely priced in for May, while implied rates based on swaps rates show there is a nearly 22 percent chance of a rate hike in March. BOEWATCH
Speculation of a near-term rate hike has gained momentum on expectations that annual inflation will pick up, having already hit an eight-month high of 3.7 percent in December, almost twice the central bank’s target.
RBC Capital said in a note that next week’s inflation report may show more upside risk to inflation in the medium term compared to November, and that will give the market a clue as to when the BoE will raise rates and how aggressive it will be.
Minutes of the BOE’s recent policy meetings have recorded a more hawkish tone, with two members voting for a rate hike last month. The minutes showed Martin Weale had joined Andrew Sentance in voting for rates to be raised, giving sterling bulls a huge boost.
Analysts say more members could sway towards raising rates as the BoE fights to regain its inflation-fighting credibility.
March gilt futures and short sterling interest rate futures moved little after the BoE rate decision, suggesting a rate hike next month is not ruled out if the tone of the inflation report is more hawkish. [GB/]
“The appetite for buying the pound on dips remains in place,” said Daragh Maher, deputy head of global foreign exchange research at Credit Agricole.
Expectations of a rate hike have remained strong despite a shock contraction in Britain’s economy at the end of 2010. Analysts said slowing growth prospects, lower government spending and rising unemployment could heighten the BOE’s dilemma over when to tighten policy. Data on Thursday showed British factory output fell unexpectedly in December, but a weather-related surge in energy production offset the decline, and economists said they expected a manufacturing bounce-back in January. [ID:nLDE7190V7].
Markets expect the BoE to tighten rates before the European Central Bank.
The euro EURGBP=D4 fell more than 0.6 percent to 84.72 pence, with near term support seen near its 200-day moving average which comes in at 84.529 pence.
The single currency was under broad pressure as worries about the euro zone debt crisis and the lack of a quick solution were starting to emerge and as speculation waned that the ECB will raise rates soon. (Editing by Catherine Evans)