The pound hit a 20-month high against the euro and a near six-month peak against the dollar, extending its recent gains made on data showing an improvement in the UK economy and as investors price out the likelihood of more quantitative easing by the Bank of England.
But having advanced strongly in the past week, some investors were cautious ahead of UK gross domestic product data for the first quarter due out on Wednesday. The data is likely to show the economy grew a modest 0.1 percent after shrinking 0.3 percent in the last quarter of 2011.
Some analysts see a risk of GDP showing a further contraction due to very weak construction output, and this could weigh on sterling. However, it may only be short-lived given a much more worrying euro zone economic outlook.
GDP data will set the starting point in terms of whether there will be more QE. It will show whether the economy is improving and give a sense of the trajectory of growth going forward, said Lauren Rosborough, currency strategist at Societe Generale, which sees euro/sterling falling to 80 pence in the medium term.
The euro fell to 81.435 pence, just above a low of 81.43 pence hit in August 2010. It pared some of those losses to trade at 81.80 pence in afternoon trade as some investors booked profits on bearish bets initiated earlier.
Against the dollar sterling rose to $1.6164, its strongest since October 31, 2011. SocGen's Rosborough said the pound could struggle to vault $1.62 against the dollar.
The pound's trade-weighted index also matched Monday's high of 83.2, its highest level since August 2009, Bank of England data showed.
Sterling's outperformance comes amid political uncertainty - specifically over the Netherlands and France - and growing worries about the outlook for the euro zone and worsening debt problems in peripheral countries, particularly Spain. As a result, many see sterling gaining further towards 80 pence per euro.
There is generally a bid tone for sterling against the euro. Before the end of the second quarter I'd expect to see euro/sterling around 80 pence, if not lower, said Michael Derks, currency strategist at FXPro.
There is a tendency among investors not to have too much currency exposure to the euro, so receivables in euros are getting hedged into other currencies and sterling is one of them.
REVISION IN FORECASTS
Barclays raised their forecasts for sterling, and now see it strengthening to 79 pence in three months and 76 pence in 12 months (from previous forecasts of 84 pence and 80 pence respectively), based on a more favourable UK economic outlook.
Upside risks to our very weak UK growth outlook and sticky inflation mean the Monetary Policy Committee's current stance may be too accommodative, their analysts said in a note to clients.
Sterling has posted solid gains since Bank of England minutes last week suggested the committee would not vote to inject more monetary stimulus into the economy as it fears inflation will now be greater than expected.
Figures on Tuesday showed Britain's public sector budget deficit was higher than expected in March, though downward revisions in previous months meant the government met its full-year target.
But traders said it may struggle to extend gains versus the U.S. currency, with stiff chart resistance from a trendline drawn from a high in late December at $1.6163, while just above that is the late October high at $1.6167.
Given the UK's strong ties to an increasingly slowing euro zone, we like to sell sterling/U.S. dollar near technical resistance at $1.6170, Morgan Stanley analysts said in a note.
(additional reporting by Jessica Mortimer; Editing by Stephen Nisbet)