Sterling retreats from recent highs as political risks weigh

(Updates prices, adds details on U.S. dollar)

LONDON, March 2 (Reuters) - Sterling fell on Monday, retreating from a seven-year high against the euro and an eight-week peak against the dollar as the prospect of an unsettling British parliamentary election in May clouded the outlook.

Data showing British house prices fell in February for the first time in five months also hurt sentiment. A survey from Nationwide showed annual house price growth of 5.7 percent, the lowest since September 2013.

The euro was up 0.5 percent at 72.90 pence, recovering from a seven-year low of 72.35 struck in Asia. Against the dollar, the pound was down 0.5 percent at $1.5362.

It failed to get much of a lift from a survey that showed British manufacturing growth at a seven-month high in February and trailed the dollar as the gap between 10-year U.S. and British government bond yields widened.

Last week, sterling hit a more than six-year high against a trade-weighted basket of currencies on expectations the Bank of England could deliver an interest rate hike early in 2016.

But analysts at major banks have flagged risks to sterling from the May 7 election, set to be the closest in modern British history.

Worries over heavier spending and taxes and regulation of the financial sector by a potential centre-left Labour government top the list.

But the increased potential that Britain could leave the European Union if the ruling Conservatives win is also undermining sterling. Under pressure from the anti-EU UK Independence Party, which has recently won two parliamentary seats, the Conservatives have promised a referendum on EU membership within two years if they win.

Options market pricing shows a jump in the cost of hedging against volatility around the parliamentary election date. Three-month implied volatility traded around 9 percent compared to 7.5 percent for the two-month option.

Nevertheless, with the European Central Bank embarking on a 1.1 trillion euro asset purchase programme, and the Bank of England likely to tighten in time, monetary policy divergence will continue to drive euro/sterling in the near term.

"With Governor (Mark) Carney easing traders' fears by illustrating UK inflation risks as temporary, and very little positive economic news coming out of Europe, euro/sterling looks set for a future downside move to 70 pence," said Jameel Ahmad, chief market analyst at FXTM. (Editing by Kevin Liffey)