Sterling edged higher against the dollar on Monday as a sharp drop in oil prices eased worries about energy-driven inflation and tempered expectations for further Bank of England tightening ahead of this week's policy meeting.
The pound rose 0.07% to $1.3330 by 1010 GMT, recovering for a second straight session from Thursday's three-week lows.
Brent crude prices plunged 9% to $87.84 a barrel after the U.S. and Iran paused strikes over the weekend, boosting hopes of de-escalation. The flare-up in hostilities had last week briefly pushed oil prices above $100 a barrel, stoking concerns about its impact on inflation.
Two-year gilt yields - which are more sensitive to the near-term outlook for interest rates than other maturities - fell 6 bps to 4.362%, a steeper decline than that seen in equivalent U.S. and German government bonds.
The BoE is widely expected to leave rates unchanged at 3.75% on Thursday after inflation came in below the central bank's forecasts in June.
However, economists and markets remain divided over the longer-term outlook, with higher energy prices threatening to complicate the inflation picture. Money markets are pricing in roughly an even chance of a September rate hike.
"If inflation is still expected to remain contained, we believe the BoE will leave rates unchanged for the rest of the year," wrote ING FX strategist Francesco Pesole, adding that a dovish repricing remains "the clearest near-term risk for sterling."
Against the euro, sterling strengthened 0.2% to 84.55 pence , extending its recovery from a more than one-year low of 84.5 pence touched on July 15.
"Our short-term valuation models still suggest the pair is cheap at these levels," Pesole said.
NEW GOVERNMENT, NEW RULES?
Investors are also assessing the fiscal outlook under Britain's new government after Prime Minister Andy Burnham and finance minister John Healey took office last week.
Burnham's administration intends to preserve the previous administration's pro-growth approach to the financial services sector including regulation, a person familiar with the matter told Reuters on Friday.
Healey has retained several Treasury ministers who served under his predecessor Rachel Reeves, a signal of continuity of purpose on financial services, the person said.
Positioning data also pointed to improving sentiment toward the currency. Speculators reduced net bearish bets on sterling for a fourth straight week ahead of Burnham's move into Downing Street.
Net short sterling positions fell to $4.64 billion in the week ended July 20 from $5.96 billion a week earlier, according to data from the U.S. Commodity Futures Trading Commission.
