LONDON Dec 13 Sterling fell on Friday, heading back towards a one-month low against the euro as higher short-term euro zone market rates lifted interest rate differentials in favour of the common currency.
The pound also slipped against the dollar as investors trimmed long bets before a Federal Reserve policy meeting next week and a slew of British data including unemployment.
While the consensus is that the Fed will not start withdrawing stimulus this month, talk that it may has increased, lifting U.S. bond yields.
The euro rose 0.1 percent to 84.23 pence, not far from Thursday's one-month high of 84.315 pence. It has risen 1.4 percent in the past month as the yield gap between short-dated British gilts and German yields narrowed to its lowest since early September.
The euro has gained broadly due to the European Central Bank's reluctance to loosen monetary policy further.
As banks shy away from lending to each other towards year-end, inter-bank lending rates in the euro zone have risen to their highest in nearly 16 months, lifting the euro.
Repatriation of funds by European banks to shore up their balance sheets has also helped the currency.
However, some said the euro could dip once year-end factors were out of the way.
"Once the year-end is out of the way, we will see short rates in the euro zone stop climbing but that doesn't mean they will come down. That should cap euro strength," said Geoffrey Yu, currency strategist at UBS.
The bank expects euro/sterling to dip towards 81 pence in 12 months, with sterling driven by a bounce in the UK economy.
The pound was marginally lower at $1.6342, on track for its third day of losses. It hit a two-year high of $1.6468 earlier this week.
The pound has been hit by profit-taking after a long rally - driven by optimism about the strength of the UK economy and bets the Bank of England could be the first major central bank to raise rates - from below $1.50 in July.
The pound's strength could be tested next week by inflation and unemployment data and minutes from the Bank of England's December meeting.
"The sterling/dollar recovery appears to be losing momentum," Morgan Stanley said in a note. "The $1.6260 level remains key (to) the medium-term outlook. Holding above here is essential to maintain the bullish outlook, allowing a re-test of the $1.6465 highs. A move below the $1.6260 level would open the way for a more significant correction of recent gains."