Sterling slips vs euro, robust UK outlook still supportive

By Anirban Nag

LONDON, March 28 (Reuters) - Sterling cut gains against the euro on Friday as traders who had sold the common currency on expectations of a sharp drop in German inflation were forced to buy it back after data showed only a slight easing in price pressures.

But the pound gained against the dollar as investors bet that UK purchasing managers' indexes (PMIs) due for release next week would show that Britain's recovery is on a much stronger footing and boost chances of a rate hike in 12 months' time.

Those expectations outweighed a bigger-than-expected current account deficit for Britain in the fourth quarter.

The euro recovered to trade at 82.75 pence, having fallen to its lowest level since March 6 at 82.47 pence earlier in the day. It bounced back after German consumer prices rose by 0.3 percent on the month and 0.9 percent on the year in March. It was slightly lower than expectations of a 0.4 percent reading for the month and a 1.1 percent rise annually.

"German inflation, although on the lower side, was not too low to prompt investors to price in more chances of a rate cut next week by the ECB," said a spot trader. "So there is some short-covering taking place before the weekend."

Against the dollar, sterling rose to $1.6225, recovering from around $1.6607 struck after the UK current account data showed a deficit of 22.4 billion pounds, slightly lower than 22.8 billion in the third quarter but much higher than forecasts of a 14 billion pound gap.

FADING RALLY

"The current account numbers were disappointing, driving the pound lower against the dollar," said Philip Hoey, account manager at Caxton FX. "The rally that we saw yesterday after the retail sales data seems to be fading."

The pound rallied on Thursday after British retail sales data beat expectations.

A day earlier, Bank of England policymaker Martin Weale said a more robust economic recovery would mean a gradual increase in interest rates next year. He said signs that wage growth was picking up boded well and rates could not stay at record lows forever.

"More positive data surprises from the upcoming UK PMIs could keep investors betting on early stimulus withdrawal. Further, after Weale's comments, investors could increasingly challenge the Bank's definition of "gradual" increases," Citi said in a note.

"This could keep tailwinds for sterling in place for some time to come."

Some traders said investors were buying pounds on dips on the expectation that the UK economy will do better than the euro zone in the second quarter, putting upward pressure on gilt yields and making sterling more attractive.

"It appears likely that the UK economy will continue to outperform its peers, to the benefit of the risk asset-related capital flow situation," Manuel Oliveri, currency strategist at Credit Agricole (TLO: ACA.TI - news) , said in a note.

Despite the euro's recovery, investors remain cautious as euro zone policymakers are trying their best to tame the euro's recent strength. Euro zone inflation data for March is due on Monday, while the ECB is due to meet on Thursday.

The data and meeting have assumed greater significance after Bundesbank President and ECB Governing Council member Jens Weidmann said this week it was not "out of the question" for the ECB to buy bank assets to fight deflation - a softening of the German central bank's strict stance on the issue.

Any further easing of ECB policy would be expected to weaken the euro against its major peers. (Editing by Gareth Jones)