Dec. 10 (Bloomberg) -- The pound slid to an all-time low against the euro, reaching 88 pence, after a report showed the U.K. economy may contract at the fastest pace in 18 years this quarter, strengthening the case for interest-rate cuts.

The British currency also fell to its weakest level on record versus the currencies of its main trading partners, a Bank of England index showed. The National Institute for Economic and Social Research said today the U.K. economy shrank 1 percent in the three months through November and may contract more than that in the final three months of the year. U.K. Chancellor of the Exchequer Alistair Darling said policy makers shouldn’t use interest rates to support the currency.

“The trend is your friend and the trend is toward higher euro-sterling and I think that’s going to persist,” said Steven Barrow, head of G-10 research at Standard Bank Plc in London. “The pound is generally seen as a riskier currency than the euro.”

The pound weakened to 88.004 pence per euro, the lowest level since the single currency’s debut in 1999, from 87.60 pence yesterday. It traded at 87.71 as of 5:23 p.m. in London. The British currency fell to 79.7, from 80, against the Bank of England’s trade-weighted basket of currencies. Against the dollar, it rose to $1.4850, from $1.4750.

The pound slipped 16 percent against the euro and 25 percent versus the dollar this year as the Bank of England reduced its benchmark interest rate to 2 percent from 5.5 percent to fend off the U.K.’s first recession in 17 years. The European Central Bank reduced its key rate to 2.5 percent from 4.25 percent since September.

Darling Comment

The pound may weaken to parity with the euro during the second quarter, according to technical analysis, strategists at MIG Investments SA wrote in a report today.

A declining pound will bolster the British economy and the Bank of England shouldn’t target the value of the currency in setting interest rates, Darling said.

“The depreciation, that does clearly help our exporters,” he told Parliament’s Treasury Committee in London today. “Our policy is to target inflation, not to target the currency.”

U.K. policy makers are considering plans to pump billions of pounds into the economy as a bank-rescue package and the lowest interest rates since 1951 fail to halt a slide into a recession, a government spokesman said today.

The Bank of England and the Treasury are looking at a range of options, including “quantitative easing,” where authorities inject money into the economy by bolstering bank reserves, according to the Treasury spokesman.

‘Stay Short’

The pound may weaken beyond 90 pence per euro within the next month before strengthening to 80 pence at the end of 2009 as the recession deepens in Europe, Barrow said.

The U.K. economy will deteriorate more than is implied in the current sterling price, sending the pound lower versus the dollar and the yen, according to Societe Generale SA.

“Staying short of sterling continues to be a key conviction of ours,” a team of fixed-income and currency strategists headed by London-based Vincent Chaigneau wrote in a report. “We do not judge that all the bad news is fully priced in the currency.” A short position is a bet that the price of a currency or asset will fall.

U.K. government bonds rose, pushing the yield on the two-year gilt down seven basis points to 1.83 percent. The 4.75 percent security due June 2010 added 0.10, or 1 pound per 1,000-pound ($1,485) face amount, to 104.27. The 10-year gilt yielded 3.57 percent.

Gilts returned 8.5 percent this year, compared with 10.4 percent for European bonds and 11.9 percent for Treasuries, according to Merrill Lynch & Co.’s U.K. Gilts, EMU Direct Government and U.S. Treasury Master indexes.

The market for gilts may get “a lot more difficult” in the second half of 2009 if the economic stimulus packages being put in place now begin to lift the U.K. out of a recession, Laurence Mutkin, head of European fixed-income strategy at Morgan Stanley in London, said in a Bloomberg Television interview today.

To contact the reporters on this story: Matthew Brown in London at mbrown42@bloomberg.net

Last Updated: December 10, 2008 12:46 EST