July 24 (Bloomberg) -- The pound fell the most in a month against the euro after a report showed the U.K. economy shrank more than twice as much as economists forecast.

The currency also dropped versus the dollar, paring a second straight weekly advance, as Britain’s Office for National Statistics said gross domestic product contracted 0.8 percent in the first quarter, more than the 0.3 percent median forecast of 32 economists in a Bloomberg survey. The pound gained earlier after Bank of England policy maker Andrew Sentance said there may be “evidence of positive growth in the second half.”

“The numbers were disappointing, they suggest that the economy is still on an unstable footing and that hit the pound,” said Lee Hardman, a foreign-exchange strategist in London at Bank of Tokyo-Mitsubishi UFJ Ltd. “There’s a lot of optimism built into the pound’s valuation.”

The pound weakened to 86.51 pence per euro as of 5:30 p.m. in London, from 85.82 pence yesterday, for the biggest drop since June 23 based on closing prices. It was at $1.6435, from $1.6479 yesterday, after earlier rising to $1.6542, and depreciated to 155.76 yen, from 156.42.

The U.K. economy shrank 5.6 percent from a year earlier, the most since records began in 1955, the statistics office said. The pound may trade between $1.50 and $1.55 in 12 months, according to Hardman. The pound will reach $1.63 by the end of the second quarter of 2010, according to the median of 31 forecasts in a Bloomberg survey.

Gilts Pare Decline

Gilts gained, erasing an earlier loss that pushed the 10- year yield to the highest level in almost six weeks.

The yield on the 4.5 percent security due March 2019 dropped 1 basis point to 3.96 percent, after earlier climbing to 4.01 percent, the highest level since June 11. The price increased 0.05, or 50 pence per 1,000-pound ($1,643) face amount, to 104.29. The two-year note yield dropped 3 basis points to 1.31 percent, up 16 basis points in the week.

“Any hopes that we were going to see an indication that the U.K. was getting back to positive growth are going to be dashed,” John Wraith, head of sterling rate product development at RBC Capital Markets in London, said in a Bloomberg Television interview. “It throws more confusion into some of the announcements by the Bank of England.”

Gilts tumbled yesterday, pushing the 10-year yield up by the most since July 9, after Sentance signaled the central bank may pause its bond-purchase program. The comments came as the government sold 5 billion pounds ($8.2 billion) of 2042 inflation-linked bonds.

Sentance ‘Hints’

The Bank of England said March 5 it would begin buying bonds as part of a so-called quantitative easing policy designed to lower borrowing costs and revive the economy. It pledged to buy 125 billion pounds of assets, after getting permission from the Treasury to purchase 150 billion pounds.

The bank will “make a judgment about whether we need to add further to that stimulus” once the new quarterly predictions are available, Sentance said yesterday in an interview.

“What Sentance said hints to the fact that quantitative easing might be coming to a pause,” said Jason Simpson, a U.K. interest-rate strategist at Royal Bank of Scotland Group Plc in London. “We’ve also seen a risk rally with equities pushing higher, and that’s a challenge for bond markets.”

Gilts have lost investors 4.2 percent this year, compared with 0.1 percent by German government securities, according to Merrill Lynch & Co’s U.K. Gilts and German Federal Governments indexes.

The FTSE 100 Index added 0.4 percent today, posting a second week of gains.

Blanchflower’s ‘Worry’

The central bank risks cutting the economic recovery short if it doesn’t expand the bond-buying program and keep interest rates at a record low, according to former policy maker David Blanchflower.

“My worry is that the tightening comes too soon and people kill off any recovery that’s coming,” Blanchflower said in an interview with Bloomberg Television yesterday from Dartmouth College in Hanover, New Hampshire, where he is professor of economics.

The short-sterling interest-rate futures contract expiring in September dropped 3 basis points to 0.86 percent. It was 0.89 percent at the start of the week.

The Bank of England’s cut its main interest rate to a record low of 0.5 percent in March.

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net

Last Updated: July 24, 2009 12:50 EDT