Pound Surges, Gilts Slump After Bank of England Lifts Inflation Outlook

The pound gained versus the dollar and the euro after the Bank of England said it sees inflation “markedly higher” in the near term, boosting speculation that borrowing costs will rise from record low levels. Gilts slumped.

Sterling advanced versus all but one of its 16 major counterparts, snapping a two-day decline against the shared European currency. “There is a good chance that inflation will reach 5 percent later this year and it is more likely than not to remain above the 2 percent target throughout 2012,” the bank said in its inflation report today. Risks to economic growth are “skewed to the downside,” the report added.

“The reaction of the pound is predominantly due to the admission that inflation is going to hit 5 percent at some point this year,” said Elizabeth Gregory, a Geneva-based market strategist at Swissquote Bank SA. “The BOE doesn’t have the luxury of waiting for growth to solidify if it wants to maintain its credibility. They’re going to have to hike by at least the third quarter and possibly again in the fourth quarter.”

The pound appreciated 1.3 percent to 86.95 pence per euro as of 4:20 p.m. in London, after reaching 86.83 pence, its strongest level versus the common currency since March 24. Sterling rose 0.6 percent to $1.6457 and gained 0.7 percent to 133.34 yen.

Yields on 10-year gilts climbed seven basis points to 3.45 percent. They reached 3.46 percent earlier, the most since May 4. The two-year note yielded 1.07 percent, five basis points more than at the previous close. Short-sterling futures fell, pushing the implied yield on the contract expiring in March up eight basis points to 1.31 percent, indicating investors added to bets for higher central bank rates.

‘Macro-Economic Challenges’

The Bank of England left its main interest rate at a record-low 0.5 percent on May 5, three days after King indicated he favors keeping borrowing costs on hold, even as inflation accelerates at twice the bank’s 2 percent limit.

“The economic consequences of high-level indebtedness now would become more severe if rates were to rise,” King said at a committee of the European Parliament in Brussels on May 2. “I think these macro-economic challenges will last many years.”

The central bank said it still expects inflation to ease back toward its 2 percent goal by 2013, based on a chart of quarterly average projections. The bank’s forecasts for price growth are based on market expectations of a quarter-point interest-rate rise by the end of this year and a tripling to 1.5 percent in the third quarter of 2012, the inflation report said.

Interest-Rate Expectations

“People are bringing forward their predictions of when the BOE will make its first move on rates; that’s making sterling look like a reasonably sensible buy at these levels,” said Simon Derrick, chief currency strategist at Bank of New York Mellon Corp. in London.

Money markets expect a full 25 basis-point increase in the central bank’s key rate to December, Tullett Prebon Plc sterling overnight interbank average data show. Before the report, investors were factoring in a quarter-point rise in January.

A separate report today showed Britain’s trade deficit widened more than estimated in March as exports to countries outside the European Union fell. The goods-trade gap rose to 7.66 billion pounds, compared with 6.99 billion pounds in February, the Office for National Statistics said today in London. The shortfall was bigger than the 7.5 billion-pound median estimate of 13 economists surveyed by Bloomberg.

To contact the reporters on this story: Garth Theunissen in London gtheunissen@bloomberg.net; Keith Jenkins in London at kjenkins3@bloomberg.net

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

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