LONDON, Feb 18 (Reuters) - Sterling weakened against the euro on Tuesday after UK inflation dropped below the Bank of England’s target for the first time in more than four years, easing pressure on the central bank to raise interest rates.
The euro, which hit a one-year low against the pound on Monday, rose 0.4 percent to 82.34 pence, putting it on course for its biggest daily gain in two weeks.
The pound initially fell against the dollar from the four-year high it reached on Monday, dropping as low as $1.6655 . Weak U.S. data later helped it to recover to trade flat at $1.6713.
UK consumer prices rose 1.9 percent on the year in January, slowing from December’s rate of 2.0 percent. Economists taking part in a Reuters poll had expected inflation to stay at 2.0 percent.
Sterling, which faces Bank of England minutes and unemployment data on Wednesday, has been buoyant since the Bank of England last week raised its forecast for economic growth this year to 3.4 percent from 2.8 percent.
It also said in its quarterly inflation report that market pricing calling for the first tightening of policy in five years in the second quarter of next year were consistent with keeping inflation on target.
“It (the CPI data) gives the Bank of England a little bit more cover to hold to a mid-2015 tightening schedule,” said Paul Robson, strategist with RBS in London.
“It makes the market less comfortable bringing forward a rate hike.”
Robson said he expected the pound to hit $1.69 by end of the first quarter, although he added that “anything in the $1.70s would be quite a stretch for sterling”.
Kathleen Brooks, research director at Forex.com, said the pound would have to fall below $1.6450 to negate the current trend higher.
Sterling overnight inter-bank rates are pricing in a chance of a rate hike in 15 months’ time, although this is a lower chance than was priced in at the end of last week.
One trader said that many investors had been long the pound ahead of the data. “If I was long I would be taking profit,” the trader said. “Longer term, I do not think there are fundamental reasons for a trend higher from here.”
British government bond yields fell after the inflation data and 10-year bond yields were last 2.7 basis points lower on the day at 2.76 percent.
The 10-year yield gap between gilts and German bunds was 2 basis points narrower on the day at 108 bps - its tightest in a week. The gilt future was up 27 ticks on the day at 110.10, having hit a session high of 110.36 after the data.
“A drop in UK inflation to the lowest since November 2009 means the UK economy is enjoying a welcome combination of strong economic growth and low inflation,” Chris Williamson, chief economist at Markit said in a research note.
It said this added to “the scope for policymakers to keep their foot on the accelerator for longer via lower interest rates to help drive a strong and more sustainable recovery.”