Sterling stays strong above $1.70 as BoE and Fed paths diverge

LONDON, June 19 (Reuters) - Sterling hit a five-year high against the dollar on Thursday, settling above the $1.70 mark, lifted by the diverging monetary policy outlooks between the Bank of England and the Federal Reserve.

The yield gap between two-year British gilts and U.S. Treasuries widened, prompting more investors to buy sterling and putting it on course to test its 2009 high of $1.7043.

While the Federal Reserve signalled on Wednesday that rising inflation won't trigger an increase in U.S. interest rates any time soon, investors are pricing in the chance of a rate hike in Britain before the end of the year.

As a result, sterling rose to $1.7029, up 0.2 percent on the day. The pound, however, lagged the euro, with the single currency up 0.1 percent at 80.10 pence. The currency barely reacted to monthly UK retail sales data for May which showed a fall for the first time since January.

On a year-on-year basis, retail sales were slightly below expectations but it did little to alter rate hike expectations.

"These slightly worse-than-expected figures shouldn't affect the optimistic outlook for the UK economy as there was always going to be a slight drop given the unexpectedly high April reading," said Jake Trask, corporate dealer at UKForex.

Sterling has gained more than 10 percent in the past year on expectations a rapidly improving UK economy would prompt the BoE (Shenzhen: 000725.SZ - news) to raise rates before its peers in Europe and the United States. But the rally had stalled in the past month after Governor Mark Carney warned markets in mid-May not to expect swift action.

But he surprised investors last Thursday by saying rates might rise before many were predicting, prompting investors to bring forward expectations for a first UK rate hike to before the end of this year from the first quarter of 2015.

His deputy Charlie Bean added fuel to market speculation that the balance of opinion on the bank's rate-setting policy committee may be shifting in favour of raising rates. A known dove, David Miles, has also said he expects to vote for a hike in interest rates before next May.

And in line with Carney's comments last week, the minutes from the Bank of England's last meeting said the nine members of the policy committee were surprised that markets had priced in a relatively low chance of an interest rate rise in 2014.

While the BoE is preparing markets for a rate hike, Fed chair Janet Yellen indicated on Wednesday that monetary policy in the United States was unlikely to tighten anytime soon. That should boost the pound against the dollar in the coming weeks.

"Some may have expected the Fed turning a bit more hawkish, because inflation was higher, because of the BoE making a case of higher rates, but no, that did not happen," said Manuel Oliveri, FX strategist at Credit Agricole (TLO: ACA.TI - news) .

"Yellen did not really make a big point of rate increases ... She's downplaying inflation risk. There is more room for diverging Fed/BoE monetary policy expectations and for rate differentials to rise because the Fed is keeping rates more or less capped." (Reporting by Anirban Nag and Jemima Kelly; Editing by Catherine Evans)