File picture: Reuters

London - Sterling fell further from a four-year high versus the dollar and gilts rose on Tuesday after UK inflation dropped below the Bank of England's target for the first time in over four years, easing pressure on the bank to hike interest rates.

The pound, which on Monday hit a five-year high against a basket of currencies and its highest since late 2009 versus the dollar, on expectations rates would soon be on an upward path, fell to a session low of $1.6655 from $1.6686 before the data.

It recovered to trade 0.3 percent lower at $1.6670.

The euro rose to 82.38 pence from 82.21 pence.

Consumer prices rose 1.9 percent on the year in January, slowing from December's rate of 2.0 percent.

Economists taking part in a Reuters poll had expected inflation to stay at 2.0 percent.

Sterling has been buoyant since the BoE last week raised its forecast for economic growth this year to 3.4 percent from 2.8 percent.

It also said in its quarterly inflation report that market pricing calling for the first tightening of policy in five years in the second quarter of next year were consistent with keeping inflation on target.

“It gives the Bank of England a little bit more cover to hold to a mid-2015 tightening schedule,” said Paul Robson, strategist with RBS in London.

“It makes the market less comfortable bringing forward a rate hike.”

Robson said he expected the pound to hit $1.69 by end of the first quarter, although he added that “anything in the $1.70s would be quite a stretch for sterling”.

Sterling overnight inter-bank rates are pricing in a chance of a rate hike in 15 months' time, although this is a lower chance than was priced in at the end of last week.

One trader said that many investors had been long the pound ahead of the data. “If I was long I would be taking profit,” the trader said. “Longer term I do not think there are fundamental reasons for a trend higher from here.”

British government bond yields, meanwhile, extended falls after the data.

“A drop in UK inflation to the lowest since November 2009 means the UK economy is enjoying a welcome combination of strong economic growth and low inflation,” Chris Williamson, chief economist at Markit said in a research note.

It said this added to “the scope for policymakers to keep their foot on the accelerator for longer via lower interest rates to help drive a strong and more sustainable recovery.”

Ten-year government bond yields fell 4.5 basis points to 2.74 percent, pushing their premium over equivalent German Bunds 2 basis points tighter to 108 bps - the narrowest in a week.

Gilt futures hit a session high of 110.36 after the data, up 53 ticks on the day.

They stood at 110.04 before the release. - Reuters