Despite sinking rapidly against the euro as the common currency received a boost from various factors outlined below, sterling rose to a one-month high against the dollar as the US published weak data and speculation that UK interest rates may rise sooner than expected took hold.
Money markets are pricing in a rate hike by the end of the year but with a growing chance it could be as early as May BOEWATCH and the minutes of the BoE's meeting, due on Jan. 26, will be watched closely.
Meanwhile, a solid Spanish debt auction and comments by European Central Bank President Jean-Claude Trichet that the Eurozone faces short-term inflationary pressures added fuel to a short-covering rally in the euro, including against the pound.
"Sterling is being dragged up against the dollar on the back of a stronger euro after hawkish comments from Trichet and a positive auction result," said Neil Mellor, currency strategist at Bank of New York Mellon.
"There are quite a few opinions in the market on the BoE and the focus has definitely shifted to inflation and away from deflation risks," he added.
Technical analysts said the outlook for the pound had been boosted by Wednesday's close above the 100-day and 55-day moving averages for the first time in a month.
The BoE kept rates at a record low of 0.5 percent as widely forecast but rising inflationary pressures and higher UK yields have prompted money markets to price in a strong chance of a rate hike as early as May.
The euro strengthened yesterday against its major counterparts after Spain and Italy staged successful bond sales, easing concerns over an escalation of Eurozone debt strife and buying the bloc's leaders more time to come up with a new package of anti-crisis measures.
Spain sold 3 billion euros of 5-year bonds on Thursday at a yield of 4.54 percent -- nearly a full percentage point more than at a previous auction in November but well below the level some had feared.
Demand was robust with over 6 billion euros in bids and 60 percent of the debt was bought by investors outside of Spain, a source told Reuters.
Shares in large Spanish banks, whose own debt levels and exposure to a collapsed property market have worried markets, shot higher for a second day, with Banco Santander trading up 4.0 percent and BBVA rising 5.3 percent.
But in a reminder that Spain's financial sector remains vulnerable, retail bank Banesto announced its profit had tumbled nearly 20 percent last year due to bad loans and a price war for deposits.
Like Spain, Italy saw yields rise as it sold 6 billion euros in 5- and 15-year bonds, but demand was stronger than its last sale in November. Italy has largely avoided the wrath of the bond markets, but could become a target due to its high debt levels.
European Central Bank President Jean-Claude Trichet renewed a call for Eurozone governments to boost the size and scope of their 440 billion euro ($578.2 billion) rescue fund and warned of short-term inflation pressures in the Euro area.
The euro pushed up to its highest level against the dollar in a week and the risk premium investors demand to hold debt from the Eurozone's fragile southern periphery fell in a sign that investors are more confident about the bloc's determination to address its economic woes.
After a rocky start to the year, optimism was rekindled on Wednesday when Portugal attracted strong demand for its 10-year bonds and German Finance Minister Wolfgang Schaeuble promised a "comprehensive" new package of debt crisis measures by the time EU leaders meet for a summit in March.
Following rescues of Greece and Ireland last year, Portugal and Spain are seen as the Eurozone countries most at risk of a bailout and weak demand for their bonds would have aggravated jitters and raised pressure on European leaders to act fast.
"The figures look really good, it's the perfect sequel to the Portugal auction yesterday," Michael Leister, a strategist at WestLB in Duesseldorf, said of the Spanish auction.
The dollar sunk to one month lows versus Sterling on Thursday, helped by a short-covering rally in the euro and expectations from some market players that a rise in UK interest rates may come sooner than expected in 2011.
A jump in weekly US jobless claims pointed to a stuttering economic recovery, putting the dollar under further pressure.