(Updates after reaction to UK PMI data, fresh quote)
* Sterling index at highest since mid-January
* Solid UK services PMI bolsters sentiment
* SONIA curve pricing in chance of a rate hike in early 2015
By Anirban Nag
LONDON, Sept 4 (Reuters) - Sterling hit a 7-1/2 month peak against a trade-weighted basket of currencies on Wednesday, after data showed the UK services sector expanding at its fastest pace in more than six years in August.
The data added to growing evidence of a broad-based pick up in the UK economy and bolstered market expectations that the Bank of England may have to tighten monetary policy well before it has flagged.
Sterling rose to a fresh 3-1/2 month high against the euro after the PMI survey showed a reading of 60.5 in August which was better-than-expected and amongst the highest in the developed world.
The single currency fell to 84.38 pence, its lowest since mid-May, and down 0.25 percent on the day. It was trading at 84.52 before the data was released.
Against the dollar, sterling hit a session high of $1.5612 after the data, and 0.3 percent higher on the day. All of which saw sterling's trade-weighted index at 82.2, its highest since January 17.
"The services sector PMI exceeded expectations and given that construction and manufacturing were also better than expected, the recovery is broad-based and that is good news," said Sasha Nugent, currency analyst at Caxton FX.
"We expect sterling to rise, more so against the euro. The euro, we expect, to gradually drop to 83 pence."
The euro was also weighed by expectations that the European Central Bank may talk down rising short term market rates and pledge to keep policy accommodative for longer. The ECB's rate setting committee meets on Thursday.
RISING SHORT TERM RATES
Earlier this week, British construction and manufacturing sector PMIs beat expectations.
The data along with rising short-term money rates have underpinned the pound. The 18-month sterling overnight interbank average (SONIA) rate is at 0.5100 percent, up from 0.46375 percent at the end of August.
The steady rise in short term money market rates is posing a challenge to central bank Governor Mark Carney's forward guidance plan. Under the plan, Carney has pledged to keep the bank rate at a record low and monetary policy loose until the jobless rate drops to 7 percent.
He expects that level to be reached in three years from the current 7.8 percent, but markets, as reflected in the SONIA curve, are pricing in a chance of tightening in early 2015.
Morgan Stanley (Xetra: 885836 - news) strategists said there is a risk that the currency could give up some gains if the BoE warned against rising market interest rates this week. The BoE's Monetary Policy Committee starts a two-day meeting on Wednesday.
"We suggest some caution ahead of the BoE meeting where the MPC (KOSDAQ: 050540.KQ - news) has the opportunity to push back against the rise in market rate expectations developed since the announcement of guidance," Morgan Stanley said in a morning note.
(editing by Ron Askew)