Sterling firmer vs euro as GDP data highlights diverging fortunes

(Adds gilts)

By Jemima Kelly

LONDON, July 25 (Reuters) - Sterling rose against the euro on Friday after data showed Britain's economy is bigger than it was before the financial crisis six years ago, highlighting the increasingly divergent economic and policy outlooks for the UK and euro zone.

Gross domestic product (GDP) expanded by 0.8 percent in the April-June period, the same strong pace as in the first three months of the year and in line with forecasts in a Reuters poll of economists.

The data came a day after the International Monetary Fund (IMF) cited Britain as a bright spot while it cut its forecast for total global economic growth in 2014.

Earlier on Friday data showed German business sentiment falling for the third consecutive month, with the Ifo think-tank citing geopolitical tensions as affecting the business climate. Germany has strong trade links with Russia and so could be affected by tougher sanctions over the situation in Ukraine.

That followed healthier German data on Thursday showing German business activity expanding more rapidly than expected in July, with the services sector growing at its fastest in three years. That gave a boost to the euro, which had hit a 23-month low against the pound on Wednesday.

But the euro fell to 79.10 pence, down 0.2 percent on the day and on track for its second straight week of losses.

"The GDP report was bang in line with expectations, and as such it doesn't change the outlook policy significantly," said Adam Cole, G10 head of currency strategy at RBC Capital Markets, He expected the Bank of England to hike interest rates by the end of the year.

In contrast, the European Central Bank is likely to maintain loose monetary conditions, with many expecting it to opt for quantitative easing later this year. QE is seen negative for the currency as it increases supply and drives down its value.

Sterling pared some losses against the dollar after the data and was flat on the day at $1.6985. The pound slipped below $1.70 on Thursday for the first time since June after weaker-than-expected retail sales numbers cast some doubt on the case for a swift rise in interest rates.

Although the British economy has looked to be recovering strongly this year, June's retail sales added to a run of slightly weaker data. Significantly, wage growth - a key issue for central banks considering raising interest rates - was shown earlier in the month to be lagging inflation.

"It doesn't do too much for rate hike expectations though, with some investors recently pushing back their calls for a rate hike to first-quarter 2015," said Alex Edwards, head of corporate desk at UKForex.

"The headlines indicate that all is rosy again but it isn't quite with average earnings struggling to keep pace with the improving jobs numbers. It indicates that there is still quite a lot of slack in the economy."

GILTS

UK gilt futures were up 40 ticks on the day at 111.17 at 1354 GMT, in line with German Bunds.

Ten-year yields were 3.8 basis points lower at 2.57 percent and thirty-year yields were 2.1 bps lower at 3.29 percent.

"We are seeing the long-end give up a bit of ground so we would argue there are some sings of a concession, (that the market is) making room for the linker deal next week," one trader said. Britain's debt management office will next week sell an inflation-linked bond maturing in 2058, via syndication.

"The geo (NYSE: GEO - news) -political noise out there is enough to keep us underpinned before the close," the trader said.

The gilts market showed little reaction to the GDP data. (Additional reporting by Anirban Nag and Ana Nicolaci da Costa; Editing by Tom Heneghan)