Pound rebounds but headwinds blow ahead of BoE decision

LONDON (Reuters) -Sterling recovered from its lowest level against the dollar since March 2020 on Wednesday, a day ahead of the Bank of England's rate decision, but the reprieve could prove temporary due to slowing economic growth and growing post-Brexit tensions.

Britain's growth prospects are seen among the weakest for rich countries in 2023, and there is uncertainty over how fast the Bank of England (BoE) - which is expected to raise interest rates again on Thursday - can tighten policy this year to tame inflation without further hurting the economy.

All but one of the 56 economists polled by Reuters last week expected the BoE to raise its Bank Rate on Thursday to 1.25% from 1.0%, but many warn a rise to 1.5% could be a close call.

The pound, which plunged below $1.20 on Tuesday for the first time since the COVID-19 crash in March 2020, bounced back as much as 1% on Wednesday and was up 0.77% at $1.2089 at 1443 GMT.

"There is little bit of bargain hunting but I suspect the market is still short on the pound," said Jane Foley, head of forex strategy at Rabobank, adding the currency's rebound was likely to be temporary.

"I think the headwinds are still there," she added, noting the fresh trading row with Brussels and a potential new independence referendum in Scotland were likely to add to the market's worries about UK growth and investments.

Britain's economy unexpectedly shrank in April after contracting 0.1% in March, the first back-to-back declines since the early days of the pandemic in March and April of 2020.

Reacting to the British government's plans to override post-Brexit trade rules for Northern Ireland, the European Commission on Wednesday launched two new legal proceedings against London and resumed another challenge it had previously paused.

Versus the euro, the pound also made sizeable gains and was up 0.7% at 86.18 pence, recovering further from its lowest level against the single currency since May last year.

Sterling's rise came as the euro trimmed gains against the dollar after the European Central Bank announced it will skew reinvestments of maturing debt to help more indebted members and will devise a new instrument to stop fragmentation of the market of euro zone government bonds.

Investors were also focused on the Federal Reserve's policy meeting later on Wednesday, for which markets are overwhelmingly pricing a 75 basis point interest rate hike as policymakers try to rein in rampant inflation.

(Reporting by Julien PonthusEditing by Mark Potter)