In UK news, Britain recorded a bigger-than-expected budget deficit of 21.53 billion pounds ($26.87 billion) in March, official data showed on Tuesday, capping off the fourth-highest borrowing for a financial year since records started.
A Reuters poll of economists had pointed to public sector net borrowing, excluding state-owned banks, of 20 billion pounds.
Sterling on Tuesday was trading down 0.2% against the dollar at $1.2463 and down 0.1% against the euro at 88.53 pence.
The pound has been one of the strongest performing major currencies against the dollar so far this year, with a gain of 3.1%, neck-and-neck with the euro for second place behind the Swiss franc, which has climbed nearly 4.5%.
Inflation running at a surprisingly hot 10.1% in March and evidence of solid service sector demand have prompted many to reassess how much more the Bank of England may have to raise rates this year.
"We still think that markets are over-estimating the amount of further tightening (71 basis points in total, including next week's hike, before reaching the peak), but unless there is a clear push-back by the BoE at the policy meeting, the pound may not lose its solid momentum just yet," ING's Francesco Pesole said.
Money market rates show traders believe there is a 99% chance the Bank of England will raise interest rates by a quarter of a point in May to 4.5%.
Further out, they now expect a peak of 4.9% by November this year, compared with a terminal rate of 4.5% in August just one month ago.
Goldman Sachs analysts said on Monday they believe the BoE will take rates to 4.7% this year, up from a previous forecast for a peak in rates of 4.3%, based on sticky inflation, ongoing wage growth and strong business activity.
Sterling has found favour with speculators in the past year and now boasts the first bullish position against the dollar since last February, according to weekly data from the U.S. Commodity Futures Trading Commission (CFTC).
Investors overall hold a $101 million long position in the pound, mostly thanks to an increase in asset manager holdings of sterling.
But, according to Kamal Sharma, who is director of G10 currency strategy at Bank of America, sterling might not have much more room to gain.
"One of our key calls this year is that GBP should benefit from the removal of tail risk premium and news flow becoming 'less bad'," he said in a recent note.
"However, this may be as good as it gets: the best of UK data surprises may be behind us and there is little encouragement that international investors are returning to UK asset markets - a necessary condition for medium-term optimism."
(Reporting by Amanda Cooper; Editing by Tomasz Janowski)
By Amanda Cooper
