Pound Slumps, Gilts Rally After King Damps Expectations of Early Rate Rise

The pound slumped and government bonds surged as investors pared their bets on higher interest rates after Bank of England Governor Mervyn King said borrowing costs may need to stay at a record low to revive the economy.

Sterling depreciated against all of its 16 most-actively traded peers. The central bank hasn’t laid the ground for an interest-rate increase, King told reporters in London today following the release of the quarterly inflation report. Inflation in the U.K. may peak at about 4.4 percent this year before reaching the central bank’s 2 percent target by the middle of 2012, the report said.

“The market has gotten it into its head that there would be three, maybe four interest rate hikes by the end of the year, but that’s too excessive,” said Neil Mellor, a London-based currency strategist at BNY Mellon. “There is clearly a fear that there will be downside risks to the economy.”

The pound fell 0.5 percent to $1.6054 at 4:36 p.m. in London, following earlier gains of as much as 0.4 percent. Sterling weakened 0.8 percent versus the euro to 84.31 pence.

The Bank of England has faced mounting pressure to raise interest rates from a record low of 0.5 percent after inflation exceeded its target for more than a year. A report yesterday showed consumer prices jumped 4 percent in January from a year earlier, forcing King to write another letter to Chancellor of the Exchequer George Osborne to explain why it remains above the 3 percent upper limit.

“Some people are running ahead of themselves in saying that we are pre-announcing, or we’re laying the ground, for a rate rise,” King said today after the inflation report was released. “That decision has not been taken and it won’t be taken until we get to the next meeting, or the following meeting. It may be many quarters before we do anything.”

‘Listen to King’

Short-sterling futures rose today, reducing the implied yield on the contract expiring in December by six basis points to 1.70 percent. A lower yield indicates investors reduced bets that policy makers will increase borrowing costs.

“People are clipping away their expectations for higher rates,” said Mellor. “You’ve got to listen to King. The market has focused too much on the inflation figures and too little on what Mervyn King has been saying.”

The inflation report still prompted Barclays Capital and Royal Bank of Scotland to bring forward their estimates for the first U.K. rate increase this year. Barclays predicts 25 basis- point increases in May, August and November, bringing the key rate to 1.25 percent by the end of the year. The brokerage had previously forecast a 50 basis-point increase in November.

‘Dovish’ Comments

The pound is weakening today because investors are disappointed by King’s “dovish” comments, said Peter Dixon, an economist at Commerzbank AG in London.

“The economy remains fragile and the BOE is not going to follow the normal pattern of putting up rates soon and regularly,” said Dixon. “If the economy continues to struggle, then King and some of the more dovish members of the MPC will continue to hold the view that inflation pressures will diminish.”

The growth outlook has worsened because of a “weak” fourth quarter, the central bank said today. King yesterday dismissed the inflation spurt as temporary, saying raising rates quickly to tame the surge may hurt the economy, according to his letter to Osborne.

U.K. government bonds rallied, pushing the yield on the two-year note down by five basis points to 1.50 percent. The 4.5 percent security due March 2013 rose 0.10, or 1 pound per 1,000 pound face amount, to 106.04. Ten-year gilt yields slid four basis points to 3.81 percent.

To contact the reporter on this story: Garth Theunissen in London gtheunissen@bloomberg.net

To contact the editor responsible for this story: Daniel Tilles at dtilles@bloomberg.net

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