(Reuters) - Sterling hit a two-month high against the euro on Monday after a UK manufacturing survey bolstered expectations of monetary tightening earlier than flagged by the Bank of England. The euro fell to 84.72 pence after the Purchasing Managers' Index (PMI) survey was released from 84.955 pence beforehand. The survey showed that new orders and output hit their highest levels in nearly two decades in August. Sterling rose to $1.5594 from $1.5553 beforehand. The pound was also buoyed by prospects of merger and acquisition-related inflows as Vodafone, a British company, neared the sale of its 45 percent stake in Verizon Wireless to Verizon Communications for $130 billion. The stronger-than-expected PMI data drove the 10-year British gilt yield to its highest since July 2011 at 2.856 percent. That pushed the yield gap between 10-year British gilts and German bunds to three-year highs. The spread between the interest rate sensitive two-year gilts and German bond yields also picked up, giving the pound a boost. "We continue to hold short euro/sterling," said Alvin Tan, currency strategist at Societe Generale. He expected continued outperformance of the UK economy relative to the euro area. The final reading of Germany's manufacturing PMI rose to 51.8 in August from 50.7 in the previous month, but was slightly lower than the preliminary reading of 52. The UK services sector PMI is due later this week and is expected to show growth. Earlier in the day, a survey showed British manufacturers are planning the fastest increase in capital investment in the year ahead since before the financial crisis. SHORT TERM RATES A better set of data will push up short-term money rates in the UK and challenge BoE Governor Mark Carney's forward guidance plan. Under the plan, Carney has pledged to keep the bank rate at a record low of 0.5 percent and monetary policy loose until the jobless rate drops to 7 percent. He expects that level to be reached in three years' time from 7.8 percent currently, but markets are pricing in a chance of a rate hike in early February. After the UK PMI survey, the 18-month sterling overnight interbank average rate was at 0.49625 percent, up from around 0.45125 percent on Friday. Investors will be wary of any statement highlighting concerns about rising yields after the BoE policy meeting ends on Thursday. After the BoE policy meeting, investors will turn their focus to U.S. jobs data for August. The data could be key to whether the Federal Reserve will start unwinding monetary stimulus this month or not. "If the BoE does stick to its dovish script while the Fed starts to slow down its bond buying, sterling/dollar is likely to fall into a lower $1.40-$1.50 range," said Mansoor Mohiuddin, chief currency strategist at UBS.

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