Sterling treads water at 3-month low after weekly drop on dollar rally

LONDON, Sept 25 (Reuters) - The pound held steady on Friday at around its lowest in just under three months against the euro and dollar, with the US currency set for a second sharp weekly increase on rising energy prices and rate hike bets.

Sterling was little changed at $1.322, after falling to $1.32 on Thursday, its lowest since June 29.

Britain's currency was on track to fall 1.2% against the dollar in its biggest one-week fall since May, after declining 1% the previous week.

The dollar has rallied this week as traders raised their bets on further rate hikes from the US Federal Reserve.

Rising energy prices as conflict in the Middle East disrupts energy flows, as well as strong economic growth, have prompted Fed officials to talk up the chances of more rate increases after the central bank raised borrowing costs last Wednesday.

The Bank of England held rates steady last week, in contrast with the Fed and European Central Bank, although it flagged the possible need for increases should the US-Israeli war on Iran drag on.

Expectations of higher interest rates tend to push up yields on a country's bonds, making them more attractive and raising demand for the currency.

The pound eased against the euro to its lowest in three months, with the euro zone's currency reaching 86.11 pence.

Francesco Pesole, currency strategist at ING, said the pound is likely to struggle in the coming months as it is doubtful the BoE will hike interest rates sharply.

"It seems unlikely the BoE will match market expectations for further tightening, meaning some large dovish repricing should still occur at some point," he said.

Traders in money markets expect around 35 basis points of monetary tightening from the BoE this year and more than 100 basis points by the end of 2027, although economists broadly expect much more limited action.

Markets also expect around 100 basis points of further tightening by the end of next year from the ECB, which has already raised interest rates twice this year.

(Reporting by Harry Robertson; Editing by Kirsten Donovan)