* Graphic: sterling and gilt yields bit.ly/2dgAXn1
* Graphic: World FX rates in 2017 tmsnrt.rs/2egbfVh
* Graphic: Trade-weighted sterling since Brexit vote tmsnrt.rs/2hwV9Hv (Adds context about Brexit+BoE, new quotes)
By Fanny Potkin
LONDON, Oct 9 (Reuters) - Britain’s pound rebounded from its biggest weekly drop in a year on Monday as stronger labour costs data hardened expectations of higher interest rates, and after Prime Minister Theresa May vowed to ward off challenges to her leadership.
Sterling rose half a percent to $1.3180 — recovering from the 2.5 percent it lost last week — and was the biggest gainer among major currencies against a broadly muted dollar in a market thinned by holidays in major markets.
British labour costs have been growing more strongly than previously announced, the Office for National Statistics (ONS) said, adding to the case for a first interest rate hike by the Bank of England in more than a decade.
“There’s a case to be made for both politics and economics supporting today’s rise in sterling,” said David Cheetham, chief market analyst at XTB.
Cheetham said the ONS correction “should feed through higher prices and impart further pressure on the Bank to follow through on... a rate hike.”
Expectations of interest rate hikes have grown in recent weeks after the BoE signalled it was prepared to increase rates in the “coming months” in mid-September. Futures markets are pricing in more than 50 basis points of hikes over the next year.
May, meanwhile, hinted at the weekend that she may be considering a cabinet reshuffle to reassert her authority, raising questions over the fate of foreign minister and Brexit campaigner Boris Johnson, who has been accused of undermining her.
The pound has become more sensitive to political noise in recent months and some strategists said Johnson’s departure, if it happens, could increase the chances of a “soft Brexit”, which might be positive for sterling in the short term.
“If Boris Johnson were to leave or be demoted as the weekend press is suggesting, that would be showing May’s leadership and that her vision of Brexit is the one that will be going forward and that markets should be aligned to,” said Viraj Patel, an FX strategist at ING Bank in London.
Britain and its European Union partners clashed on Monday over which side should make the next move to unblock Brexit talks, despite concerns they will miss a deadline for a divorce deal and that London is heading for a chaotic departure.
“The EU’s lack of willingness to begin talks over a new special relationship highlights the need for the UK government to prepare more intensively for a no deal scenario even if it is not the desired outcome,” warned currency analyst Lee Hardman in a note for MUFG.
Against the euro, sterling climbed half a percent to 89.37 pence.
Reporting by Fanny Potkin; Editing by Saikat Chatterjee/Jeremy Gaunt