Sterling firms as focus turns to UK fundamentals, rate outlook

LONDON, Sept 22 (Reuters) - Sterling rose against the dollar on Monday and inched back towards recent two-year highs against the euro as investors refocused on Britain's economic fundamentals and interest rate expectations after Scotland's independence referendum.

The euro traded 0.3 percent lower against sterling at 78.48 pence, not far off a two-year low of 78.10 struck on Friday amid relief over the Scots' decision to stay inside the United Kingdom.

The pound rose 0.3 percent against the dollar to trade at $1.6335, with the greenback under some pressure after posting its 10th straight week of gains last week.

"We continue to see further upside to sterling this week as the currency should now return back to fundamental drivers, with the UK data obtaining more prominence again," said Petr Krpata, currency strategist at ING.

"We still think that the pound has to do some more catching up following last week's back-to-normal correction in short-end UK yields."

He added that the UK two-year bond yield was not far from its July highs and a break above those levels would take it to its highest in over three years, giving sterling a boost.

With the uncertainty over the Scottish referendum out of the way, investors judged that one more obstacle to an interest rate hike from the Bank of England had been cleared.

Sterling overnight interbank average rates are pricing in the chance of a first rate increase by the BoE in the spring of 2015. Analysts said sterling stood to gain more against the euro and yen since both the European Central Bank and the Bank of Japan are likely to stick with ultra-loose monetary policies.

ECB chief Mario Draghi told European lawmakers that monetary policy would remain expansionary for a long period and the Bank was ready to use additional tools to spur inflation and growth in the euro zone.

In contrast, the U.S. Federal Reserve reiterated last week that, while rates would be maintained near zero for a considerable time, hikes could come at a faster rate next year and in 2016. By nudging up its expected path of interest rate increases - or "Fed dots" - it boosted yields on U.S. notes, and hence the appeal of the dollar.

Although the dollar gave back some of its gains on Monday, traders said the pound's rebound against the greenback would be limited in the longer term. Although the prospect of Scottish secession has gone, the uncertainty over future constitutional changes that the vote has triggered could hurt investment, they said.

"Political uncertainty is set to remain as the general election approaches next year and there is a constitutional debate regarding providing more powers to Scotland in combination with changes to English MPs only voting on English issues," Morgan Stanley (Xetra: 885836 - news) said in a note.

In other words, if the opposition Labour Party forms a national government next year with the support of non-English MPs, it could face major problems passing legislation applicable only to England if it had no majority amongst lawmakers from England.

"We expect sterling/dollar rebounds to remain limited, keeping the downtrend intact," Morgan Stanley note added.

Meanwhile, long-dated British government bond prices rose moderately, regaining some of their heavy losses in the two weeks leading up to the Scottish independence referendum, while outperforming German Bunds and U.S. Treasuries.

The 30-year gilt yield touched a session trough of 3.10 percent, its lowest level since Sept. 5, before rebounding to around 3.11 percent at 1357 GMT - up 3 basis points on the day. (Reporting by Anirban Nag and Andy Bruce; Editing by Kevin Liffey)