* BoE's Posen says call to drop QE premature
By Philip Baillie
LONDON, May 18 (Reuters) - Sterling hit a two month low against the dollar on Friday before recovering slightly, and remains vulnerable to the euro zone's mounting problems because of the UK's close links to the region.
Earlier in the session, risk aversion drove the pound to a two-month low of $1.5732, before recovering to trade at $1.5825, up 0.2 percent on the day.
Concerns about the future of the euro zone have seen investors hungry for the safety of the dollar and the yen. Moody's downgrade of 16 Spanish banks late on Thursday, including the euro zone's largest Banco Santander boosted the demand for these safe-haven currencies.
This came as Spanish banks' bad loans rose in March to their highest in 18 years and kept the kept Spain's borrowing costs at elevated levels.
Despite Friday's recovery, the pound is on track for its third straight week of losses and has lost 2.5 percent against the dollar so far this month.
But its losses were less than the euro's 4 percent losses against the dollar so far this month. The euro hovered above 3-1/2 year lows of 79.50 pence hit on Wednesday, trading at 80.30 pence as investors pared bearish bets ahead of this weekend's G8 summit.
The euro also found some support after talk of a ban on naked short-selling of Spanish banks lifted European banking shares.
Jaco Rouw, a fund manager at ING Investment Management said he expected euro to drop both against the dollar and sterling if the situation in Greece or the banking problems in Spain escalate.
"Euro/sterling started falling since early April and euro/dollar more strongly from early May. Cable is now in line with what you would expect to be a fairer target," he added.
While euro zone worries have seen safe-haven inflows into gilts, giving the pound a boost against the euro, an overall loss of risk appetite and concerns about UK's trading and financial sector exposure to Europe has driven investors to cut bullish bets on sterling against the dollar.
CUE UP FOR QE
Next week, the pound is likely to take cue from the minutes of the latest Bank of England policy meeting. The minutes are likely to reinforce it was a close call to pause asset purchases earlier this month.
But the case for further easing ahead is likely be supported by both moderating inflation pressures in April and sluggishness in retail sales growth. Both inflation and retail sales data will be released next week.
The Bank of England's quarterly Inflation Report released on Wednesday left the door open for further quantitative easing, weakening investor appetite for the pound.
Policymaker Adam Posen said in an interview on Friday he may have been premature in dropping his call for additional stimulus last month, because the underlying economy may be weaker than he thought earlier this year.
Posen has been a dove in the BoE's monetary policy committee but recently dropped his call for asset buying, giving a huge boost to the British pound. More QE is usually considered negative for the currency.
"It is interesting that these QE noises are being made right now - this could suggest heightened risk of an emergency (between-meeting) policy decision, or a coordinated policy response by central banks to any potential escalation of Greece jitters," UBS told clients in a research note. (Editing by Jeremy Gaunt)
