Sterling fell 0.5 percent to $1.6203, retreating from a three-month high of $1.6307 hit on Wednesday. Some strategists said it looked vulnerable to further selling. Against the euro, sterling was close to flat on the day at 81.36 pence, not far from the 7-1/2 month high of 81.68 pence on Wednesday. Some strategists said the pound could struggle against the euro next year if the UK budget deficit prompts ratings agencies to strip the UK of its prized AAA credit rating.
"If the news (on the US fiscal issue) remains bad for a few sessions, cable (sterling/dollar) could potentially fall due to dollar strength," said Jane Foley, senior FX strategist at Rabobank. In the options market, near-term implied volatility rose as uncertainty about the budget talks grew. Demand to hedge against excessive price swings usually rises during times of financial uncertainty.
One-month sterling implied volatility rose to 5.05, a one-month high according to Thomson Reuters data, after hitting five-year lows around 4.15 earlier this week. Some analysts said there could be more weakness in sterling next year if the UK economy continues to struggle to show signs of a recovery, prompting the Bank of England to ease monetary policy further. "The big picture is still that the UK economy is stagnating, so it is still a weak fundamental growth picture," said Lee Hardman, currency economist at Bank of Tokyo Mitsubishi.