Sterling hits 3-week low versus dollar, Middle East and gilts in focus

Sept 2 (Reuters) - Sterling hit a three-week low against a strengthening dollar on Wednesday as investors kept a close watch on the conflict in the Middle East and renewed selling pressure in the gilt market.

The U.S. and Iran were back on a war footing on Wednesday after the most significant exchange of fire in weeks. 

UK government bond yields hit fresh 18-year highs, adding to the challenge facing finance minister John Healey ahead of his first budget. 

The British pound was down 0.05% to $1.3510 after reaching $1.3490, the lowest level since August 14.

The greenback hit a two-week high as investors turned to the U.S. currency amid growing concerns about the energy shock and weighed diverging monetary policy paths across major economies. 

Healey will present his first budget on October 28 and has pledged to stick to the borrowing rules he inherited from his predecessor Rachel Reeves. 

“One-month implied volatility in sterling has fallen to more than 12-year lows, though we expect that to prove a floor for some time given brewing budget jitters,” said Matthew Ryan, head of market strategy at Ebury.

“This rise in yields, which will eat directly into the government's fiscal headroom, raises the risk of tax hikes in the autumn, even before accounting for any additional spending increases that Burnham seems likely to pursue,” he added.

The euro fell 0.05% to 85.72 pence.

The Bank of England rate path remained in the background with the BoE widely expected to leave rates unchanged at 3.75% this month, and markets pricing in a quarter-point increase by the end of the year.

“The cocktail of higher inflation, household inflation expectations and a stabilising labour market reduces the need for less restrictive policy,” Sanjay Raja, chief UK economist at Deutsche Bank, said, after flagging that his base case remains for no change to the Bank Rate.

“We think the debate around whether rates remain sufficiently restrictive will gather momentum in the coming months."

(Reporting by Stefano Rebaudo; Editing by Alison Williams)