By Naomi Tajitsu
LONDON (Reuters) - Sterling rallied to a 6 1/2-month high against the dollar on Friday as traders dumped the U.S. currency on speculation that ongoing weakness in the U.S. fiscal position may put the nation's sovereign rating at risk.
Broad dollar selling boosted sterling as high as $1.5947, putting the pound on track to post its best weekly performance versus the dollar since early February, although it fell versus the euro, which rallied close to its strongest of the year against the dollar.
The UK currency has recovered after tumbling on Thursday, when S&P surprised markets by cutting its outlook on the UK to "negative" from "stable," and saying that government debt could near 100 percent of gross domestic product.
The downgrade initially stung the pound until market participants reckoned that other countries also suffered from overborrowing, which triggered a recovery in cable.
Selling shifted to the dollar, as the UK outlook downgrade raised concerns about the United States' triple-A rating, given that it also suffers from high public borrowing, and accelerated the dollar's downward move from earlier in the week.
"There's a realisation that a lot of governments -- and there's a lot of attention on the U.S. today -- are facing far weaker fiscal positions than the UK," said Chris Gothard, currency strategist at Brown Brothers Harriman in London.
"So people are realising that just selling sterling yesterday was not the appropriate route, while the wider theme is of dollar weakness."
The pound showed little reaction to figures showing that the UK economy contracted 1.9 percent on the quarter and 4.1 percent on the year in January-March, unchanged from an initial reading.
By 3:01 p.m., sterling traded 0.3 percent higher at $1.5896, near its highest level since early November after recovering from the day's low of $1.5757.
Sterling trimmed some gains as European and U.S. stock prices relinquished early gains and headed into negative territory, but it remained on track to posting its best weekly performance against the dollar since February, having rallied more than 4.5 percent since Monday.
A rally of more than 5.0 percent on the week would be the biggest weekly gain since early 1985.
The pound's stunning gains have occurred in a week that not only saw the outlook downgrade, but also an escalation of an ongoing expenses scandal involving UK members of parliament, which plunged the House of Commons into crisis and resulted in the resignation of the speaker of the house.
Given the currency's ability to brush off negative news, market participants say the pound is heading for additional gains against the dollar, with many traders saying that a sustained climb above $1.60 is a big possibility given that the pair broke above its 200-day moving average earlier this week.
But despite gains in cable, sterling fell versus the euro, which edged up half a percent to 88.10 pence.
The euro's climb against sterling has been driven by its 3.5 percent rally against the dollar so far this week, as a darkening view of the U.S. economy and its financial woes has put the U.S. currency under broad selling pressure.
Some analysts said a bigger-than-expected rise in UK retail sales on Thursday and strong demand was a positive factor for sterling, while many remained wary of saying that the UK economy is recovering.
Bank of England Deputy Governor Charles Bean said on Thursday that the low-point in UK economic activity was not far off, but added that the strength of any recovery was uncertain and likely to be relatively low.
Analysts at Bank of New York Mellon said that sterling gains were being driven by factors other than the underlying health of the UK economy.
In a research note, they argued that the UK economic outlook remains far from certain, and that the dramatic rally in sterling is "partly a product of re-valuation and potentially a reflection of greater demands from currency reserve managers."
They said their data showed that foreign investors' cumulative net holdings of UK assets have trended modestly higher since late November, suggesting ongoing demand for UK investments after the currency tumbled broadly in autumn.
(Reporting by Naomi Tajitsu; editing by Victoria Main)