Sterling buffeted by data, political worries weigh

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By Patrick Graham

LONDON, Sept 30 (Reuters) - Sterling hit a two-week low against the dollar on Tuesday but firmed to a more than two-year high against the euro, reflecting the latest leg of a broad-based rally for the U.S. currency that dates back almost three months.

Dealers said Middle Eastern investors had been seen buying and then selling the pound after a mixed bag of data confirmed the British economy expanded strongly in the second quarter but also showed the UK current account deficit widened further.

The outlook for the pound has darkened this month, with this year's strong tone undermined first by Scotland's referendum on independence and then by the political fallout of a very close vote and doubts over the economy.

A conference this week of Prime Minister David Cameron's Conservative Party has so far served only to highlight political risks to sterling ahead of next May's parliamentary elections.

Cameron followed a handful of defections to the anti-EU UK Independence Party (UKIP) by saying on Tuesday that it "wouldn't break my heart" if Britain left the European Union in a referendum after the 2015 election.

"I'm really pretty bearish on sterling now," said Graham Davidson, a spot currency dealer with National Australia Bank in London.

"The housing market is slowing, the current account is getting worse and worse, and we are running the sort of budget deficit for which euro zone economies are getting slated. Plus the political scene is looking quite worrying."

He said the pound could head towards $1.50-1.53 in the medium term but that "might happen quicker than people expect".

Sterling fell as low as $1.6194 on Tuesday, its weakest against the dollar since Sept. 16 and more than 6 percent off its mid-July six-year peak close to $1.72.

All that said, there remain substantial sources of support for the pound. Despite some rockier signals, most banks' core scenario is that the Bank of England will raise interest rates before the U.S. Federal Reserve next year. The contrast with a euro zone that is struggling to generate any economic growth at all is more stark.

As the euro sank to its lowest in just over than two years against the dollar, the pound gained to 77.66 pence per euro, the strongest rates for sterling since July of 2012.

"We expect near-term weakness (for the pound) to continue as volatility remains elevated," Martin Arnold, global FX and rates strategist with ETF Securities, said in a note.

"Rising expectations of more aggressive action from the ECB could expose the euro to further weakness. This week's ECB meeting will be critical." (Reporting by Patrick Graham, editing by Nigel Stephenson)