By Amanda Cooper
LONDON (Reuters) - The pound edged up against the dollar on Wednesday, ahead of a monetary policy decision from the U.S. Federal Reserve and dropped against the euro, which staged its biggest daily fall against the pound in five months the previous day.
Sterling was up 0.1% against the dollar at $1.2913 and down 0.1% against the euro, which traded at 85.81 pence.
The euro tumbled by 0.7% against the pound on Tuesday, marking its largest one-day decline since February, after data showed economic growth is slowing across Europe as tighter credit conditions kick in.
However, a day ahead of a rate decision by the European Central Bank, few investors were overly willing to commit to pushing the euro much lower, given the expectation for the ECB to raise interest rates again and possibly signal more are in the pipeline.
"This is entirely a euro-driven move and does not represent some bullish re-appraisal of sterling's prospects," ING strategist Chris Turner said.
"Given that we are mildly negative on the euro going into tomorrow's ECB meeting and that UK rates might be dragged higher by U.S. rates later today, we would say euro/sterling could have a little more downside to the 85.20 area over the next couple of sessions," Turner said.
The major driver for the currency market on Wednesday was the run-up to the Fed's decision on monetary policy later on.
Money markets show traders fully expect U.S. rates to rise by another 25 basis points from their current 5.00-5.25% range and to peak around 5.45% by November.
Expectations for what the Bank of England signals when it meets on Aug. 3 have shifted this month. Traders expect UK rates to rise to as much as 5.84% by next March, from 5.0% right now, but this is well below a peak of around 6.4% by May just two weeks ago.
Evidence that UK inflation is finally starting to slow after having lingered in double digits for months, as well as a softening in business activity and a cooling in the job market has taken some of the pressure off the BoE to keep raising interest rates.
As such, some of sterling's appeal for foreign investors has faded as UK bond yields have fallen, reflecting those lower rate expectations.
Two-year gilt yields, the most sensitive to shifts in expectations for monetary policy, have fallen by 30 bps this month to below 5%, leaving their premium above equivalent U.S. yields at just 9 bps, from closer to 40 bps at the start of this month.
Against that backdrop, sterling has fallen nearly 2% in under two weeks.