LONDON, Dec 6 (Reuters) - The pound hit its strongest against the euro in three months on Wednesday, as signs of economic weakness in the euro zone and market expectations that rate cuts will come earlier next year in Europe than Britain weighed on the common currency.
The euro dipped as much as 0.22% against the pound to 85.54 pence, its lowest since early September, before recovering a touch to trade broadly flat on the day.
The pound was also steady against the dollar at $1.2603, just about keeping in sight of last week's near four month high of $1.2733.
"Bank of England policy makers have been pretty consistent in saying the labour market is too tight and it's too early to consider talking about interest rate cuts, and inflation is a bit higher in the UK than in the euro zone or the U.S.," said Jane Foley, head of FX strategy at Rabobank.
As a result "the market is thinking that the ECB could be cutting rates first, then the Fed and then the BoE."
BoE governor Andrew Bailey said on Wednesday that interest rates in Britain will need to stay at current levels for some time and the Bank is vigilant to financial stability risks that might arise from that.
Markets are currently almost fully pricing in a 25 basis point rate cut from the European Central Bank in March next year, while not pricing in a Bank of England rate cut until June.
On top of that, said Foley, recent economic weakness at the heart of Europe could hurt the common currency. German industrial orders fell unexpectedly in October, declining by 3.7% on the previous month on a seasonally and calendar-adjusted basis, the federal statistics office said on Wednesday.
"If you can be reassured that the inflationary problem is going to be under control in Europe, a weak currency could actually be quite favourable to help with the European Commission's rush to improve the competitiveness of the region," she said.
The pound's moves against the dollar have largely been driven by fluctuations in the greenback. On Wednesday, traders were waiting for the ADP National Employment Report of private U.S. payrolls, ahead of Friday's crucial jobs data.
(Editing by Kirsten Donovan)
