(Reuters) -Sterling edged up from a new 21-month low against the dollar hit earlier on Wednesday after Britain’s weak economic outlook and higher than expected government borrowing dented the Bank of England’s (BoE) monetary tightening narrative.

Money markets have been scaling back bets on the size of BoE rate hikes, pricing in 144 basis points (bps) worth of tightening by year-end from 160 bps last Friday. The pricing was at 140 bps late on Tuesday. [IRPR]

Data showed that government borrowing in the 2021/22 financial year was almost 20% higher than forecast.

British retail sales slumped in April, with the first fall in volumes in more than a year, reflecting a cost-of-living squeeze and changes in spending patterns, and adding to signs of a slowdown in the economy.

Unicredit forex strategist Roberto Mialich said he expected a further scaling back of expectations for BoE monetary tightening in the medium term as he forecast the BoE to raise its policy rate to 1.25% in the third quarter with no further increases in 2022.

“Of course, any headlines about a slowdown in growth or increasing public debt weaken expectations for future monetary tightening, weighing on the pound,” he added.

The pound rose 0.1% to $1.2584, after falling to a fresh 21-month low of $1.2536.

According to ING analysts, “markets may be positioning a bit too much on the bearish side of sterling ahead of next week’s BoE meeting, and the drop is starting to look stretched.”

Sterling was 0.3% higher versus a weakening euro at 84.29 pence after hitting its lowest since April 12 at 83.93 pence on Tuesday.

The U.S. dollar index, which measures its value against a basket of foreign currencies, rose 0.3% to 102.2 on safe-haven flows fanned by slowing growth in China and Europe.

“GBP/USD, however, could remain vulnerable as the dollar retains some momentum,” ING analysts said. “The 1.2500 support could prove a rather strong one.”

The BoE, which convenes its Monetary Policy Committee next Thursday, looks set to take its first steps towards selling some of the 875 billion pounds of government bonds it amassed between 2009 and 2021, in a move that will trigger additional monetary tightening.

But ING analysts recently argued the bank might hold off selling gilts due to the weak economic backdrop.

The BoE said it would be “considering beginning” outright bond sales when its main interest reached 1%, which is supposed to happen next week, according to market expectations.

(Reporting by Stefano Rebaudo Editing by Mark Potter)