By Anirban Nag
LONDON, April 25 (Reuters) - Sterling retreated from a 7-1/2 month high against the dollar and fell against the euro on Wednesday after data showed the UK economy had slid back into recession, keeping alive the chances of more monetary stimulus from the Bank of England.
But losses were likely to be limited by the view that Britain still has a better outlook than the neighboring euro zone and by expectations that U.S. Federal Reserve chief Ben Bernanke will strike a dovish tone when he speaks later on Wednesday.
Traders reported sovereign investors buying the pound on dips.
Data showed Britain's economy slipped back into recession as output contracted by 0.2 percent in the first three months of this year.
Sterling was last down 0.2 on the day at $1.6116, having dropped to a session low of $1.6082 after the GDP release. It traded well below the peak of $1.6172 struck earlier in the day, its highest level since early September. Traders cited stop loss orders below $1.6080.
The euro rose to a session high of 82.22 pence from around 81.87 pence before the data release, with traders saying offers above 82.20 pence were likely to check gains.
"The pound had an immediate knee-jerk lurch lower after the GDP release. Since the pound's recent strength was fuelled by expectations of a hawkish BOE, the disappointing Q1 growth data could weigh on the pound fairly heavily," said Kathleen Brooks, research director at Forex.com.
The central bank's stimulus program tends to be negative for the currency as it involves flooding the economy with billions of pounds of newly-created money.
Earlier this week the pound hit a 20-month high against the euro of 81.435 and a 2-1/2 year peak on a trade-weighted basket of currencies as investors priced out the likelihood of more quantitative easing by the BoE.
Some analysts said market players were still more focused on forward looking economic indicators.
The pound gained support from a survey from the Confederation of British Industry showing quarterly business situation balance rose to +22 in April from -25 in January, even though factory orders growth remained steady.
"While Q1 has not been particularly good for the UK the BoE has indicated they are willing to look through this quarter and look forward. The market seems to be doing something similar," said Michael Sneyd, FX strategist at BNP Paribas.
BNP Paribas forecast euro/sterling to fall to 80 pence by the middle of the year, and the mid-70s by the end of 2013.
The next focus will be the conclusion of the Federal Open Market Committee's two-day meeting. The Fed is expected to raise its growth forecasts for the U.S. economy, but Chairman Ben Bernanke is unlikely to signal a tightening of U.S. monetary policy given unemployment remains stubbornly high.
The Bank of Japan is also likely to expand its asset purchase programme later this week, while expectations are that the European Central Bank will keep monetary policy loose given the threat of recession in the euro zone.
In such an environment sterling would see demand from long-term investors, given BoE policymakers have been flagging inflation risks and a less dovish bias.
Sterling will also be buoyed by safe-haven inflows into UK gilts as political uncertainty and growing concerns about the outlook for euro zone peripheral countries sour sentiment towards the euro.
Some investors who took profit on the pound following the GDP data said they still expected longer-term strength against the euro.
"An unexpectedly weak UK GDP report for Q1 has tempered expectations the economy will outperform. We are taking profit on our short euro/sterling short position," said Ned Rumpeltin, head of G-10 FX strategy at Standard Chartered.
"Fundamentals still imply further medium-term declines, however, we will look to re-enter at better levels."Additional reporting by Nia Williams; Editing by Toby Chopra)
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