Sterling firmed against a weaker euro and turned higher versus the dollar on Monday, helped by a slight improvement in risk appetite as equities moved up on talk the European Central Bank may cut rates to help a faltering euro zone economy.
Traders also said the pound was aided by talk of a UK clearer needing to convert dollars into sterling as part of its quarterly dividend payment.
However, the pound remained vulnerable to a test of last week's one-year low against the dollar of $1.5326 on concerns a fragile UK economy could prompt the Bank of England to resort to more monetary easing.
The pound dipped briefly after BoE policymaker Ben Broadbent said the UK currency was likely to remain weak for some time and that a weak global economy would put downward pressure on inflation.
"Anything related to the risk of more QE in the UK will be zeroed-in on by the markets," said Jeremy Stretch, currency strategist at CIBC.
"This short-term spike in cable will probably just provide better levels to sell".
Speaking during a Q&A session, the BoE's Broadbent said more QE may help the banking system by boosting nominal growth.
The euro was down 0.55 percent at 86.85 pence, below its 200-day moving average around 87.08 pence and having hit a 12-day low of 86.525 pence.
Sterling rose 0.2 percent against the dollar to $1.5496, with traders citing stop loss orders ahead at $1.5520. A drop back below $1.54 would open room for a test of last week's lows, analysts said.
"Euro/sterling could see a bounce towards 87.50 (pence) if we see continued dovishness from the MPC," said Lauren Rosborough, currency strategist at Westpac.
She added that sterling was likely to be sidelined until further negative news emerged out of the UK as markets focus on the euro zone and on European leaders' proposals to shore up the bloc's EFSF bailout fund.
Positioning data suggested further weakness in sterling may be limited, however, given speculators' short positions are already elevated, leaving scope for a squeeze.
The Commodity Futures Trading Commission said speculators sharply increased net short sterling positions to their largest since February 2010 in the week to Sept. 20.
Sterling has been under pressure since the minutes from the latest Bank of England policy meeting flagged an increased readiness to ease monetary policy further.
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