Sterling knocked back by bond rout

* Graphic: World FX rates in 2020

* Graphic: Trade-weighted sterling since Brexit vote

By Joice Alves

LONDON, Feb 26 (Reuters) - Sterling fell against a stronger dollar on Friday, retreating from a three-year high touched earlier this week, as a rout in global bond markets sent yields flying and hurt the pound.

The pound has strengthened about 2% this year against the dollar and the euro as traders expect Britain's speedy vaccine roll-out will help the economy rebound from its biggest contraction in 300 years.

Analysts attributed sterling's fall on Friday to the sell-off in bond markets.

Benchmark U.S. Treasury yields vaulted to their highest since the pandemic began, driven by the prospect of accelerating growth and inflation that could trigger a faster rise in interest rates than many expect. Gilt yields also rose sharply on Thursday.

After rising above $1.42 for the first time in three years earlier this week, the pound fell to $1.3901 at 0803 GMT, its lowest since Feb. 18. It was 0.4% lower at $1.3957 at 0937 GMT

Versus the euro, it fell 0.1% 87.01, after hitting a 10-day low of 87.30 pence in earlier trading..

"The aggressive cable capitulation has seen macro and leveraged players retreating from an increasingly overbought market," said Jeremy Stretch, head of G10 FX strategy at CIBC Capital Markets. "The correction came as the UK curve 2-10 flattened by 2bp yesterday and short sterling rallied into the close."

Analysts expected further short-term weakness, but in the long term the outlook will remain positive.

"Sterling may be correcting from over-bought extremes, but provided we do not subside through $1.3840 support we would use the correction to provide better levels to enter," Stretch said.

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