LONDON, June 3 (Reuters) - Sterling held steady against the dollar and fell against the euro on Tuesday, absorbing surprisingly soft UK construction data but squeezed after weak euro zone inflation triggered a bounce in the shared currency.
In late trade in London the euro was up 0.3 percent on the day at 81.40 pence and the pound was unchanged on the day against the dollar at $1.6745.
Inflation across the 18-nation euro zone slipped to just 0.5 percent in May, increasing the likelihood of easing measures from the European Central Bank later this week and highlighting the contrast with the Bank of England, which is expected to start raising interest rates within a year.
But although below consensus, the decline wasn't a major shock after German inflation figures on Monday came in well below analysts' forecasts. Relieved that inflation wasn't even lower, traders bought the euro back and sterling suffered.
"There wasn't any additional 'fear factor' introduced and there was no real surprise, given the German numbers yesterday," said Daragh Maher, senior FX strategist at HSBC in London.
"The market was running short of euros, so we have squeezed higher. Also, there's a lot already in the price for sterling in terms of interest rate hike expectations," he said.
Financial markets expect the BoE to begin raising rates some time in the early months of next year, in stark contrast to the ECB which will still be in easing mode, and probably at least a few months ahead of the U.S. Federal Reserve.
But nascent signs of the UK housing market cooling off have tempered some of the more aggressive bets on the timing of the first rate hike, the latest being a survey on Tuesday showing that the construction sector grew in May at its slowest pace in seven months.
The Markit/CIPS UK Construction Purchasing Managers' Index (PMI) eased to 60.0 last month, below the 60.8 expected in a Reuters poll but still far above the 50 line that divides growth from contraction.
Sterling had run up to a 5-1/2 year peak against the dollar earlier in May. Over the last year the pound has appreciated some 10 percent against a basket of currencies on the growing assumption that the improving economy and red-hot housing market will force the BoE to raise rates faster than its major peers.
"The Bank will be tightening when the ECB is loosening ... but there's a somewhat dovish adjustment of UK rate expectations underway recently," HSBC's Maher said. (Reporting by Jamie McGeever; Editing by Ruth Pitchford)