Sterling's early gains fizzle as traders hedge bets ahead of BoE meeting

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British five pound banknotes are seen in this picture illustration taken November 14, 2017. REUTERS/ Benoit Tessier/Illustration/File Photo

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LONDON, Jan 17 (Reuters) - The British pound's early gains evaporated on Monday and it turned lower, away from a 2-1/2 month high, as investors consolidated bets ahead of a Bank of England meeting next month where it is widely expected to raise interest rates.

Recent data has raised expectations the British economy is rebounding strongly from the pandemic.

GDP data on Friday showed the economy is bigger than what it was before the first COVID-19 lockdown in 2020 while employment data on Tuesday is expected to be robust. read more

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Money markets are fully pricing in one rate hike by next month and one full percentage point increase in interest rates by the end of 2022.

But some economists believe the boost to the British economy from the pandemic rebound may be over and the economy is likely to face stiff headwinds in the coming months thanks to widening supply chain shortages following Brexit.

Therefore, policymakers might raise interest rates only twice in 2022, compared to the more aggressive four times being priced by the market.

"We think the UK rates market is aggressively priced for UK rate which we think will be hard to crystallise and the risks to the pound are therefore obvious," BofA strategists said.

Against the U.S. dollar, the pound edged 0.2% lower at $1.3658. It hit a late-October high of $1.3749 last week. Sterling also weakened by a similar margin versus the euro at 83.55 cents.

The pound has rallied nearly 4% since the December lows as broader currency markets have been lifted by a more optimistic global growth outlook which has resulted in a swing in trading positions by hedge funds on the pound.

The Fed's recent hawkishness has also boosted the pound's appeal as investors bet it would give the Bank of England greater confidence to raise interest rates and tighten policy.

"The Fed’s shift towards more aggressive policy action will likely push the market to expect similar moves from central banks like the BoE that were already taking steps in that direction," Goldman Sachs strategists said.

"Within this context, it is also worth noting that the Fed’s apparent preference for earlier balance sheet action makes the BoE’s own runoff plans less idiosyncratic, which we thought could have held back GBP’s response to policy action," they said, lowering their euro/pound forecast to 83 pence over the next three months from 86 pence earlier.

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Reporting by Saikat Chatterjee, editing by Ed Osmond and Mark Heinrich

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