U.K. Pound Drops, Gilts Rise on Record Decline in Retail Sales

By Agnes Lovasz

July 24 (Bloomberg) -- The U.K. pound extended declines against the euro and dollar as a record drop in retail sales fueled speculation Europe's second-largest economy is heading into a recession. Government bonds rallied.

The pound weakened from the highest level against the euro in seven weeks after a government report today showed British retail sales dropped in June by the most since at least 1986 as accelerating inflation prompted consumers to cut spending. Traders scaled back bets on higher interest rates by the Bank of England, futures trading showed.

``We're moderately negative on the pound,'' said Adam Cole, head of global currency strategy in London at Royal Bank of Canada. ``The market still has a residual expectation of a rate hike and we don't think they can possibly deliver that. That taken out, there's some downside for sterling from here.''

The pound fell to 78.91 pence per euro by 11:40 a.m. in London, from 78.50 pence yesterday, when it reached the strongest since June 2. It was at $1.9863, from $1.9995. The U.K. currency has dropped 6.6 percent versus Europe's common currency this year and gained 0.4 percent against the dollar.

The pound will slide to 81.50 pence per euro by the end of September and recover to 80 pence by year-end, Cole forecast.

Retail sales fell 3.9 percent after rising 3.6 percent in May, which was the biggest increase since the data series began more than two decades ago, the Office for National Statistics said in London. Economists had forecast a 2.6 percent drop, the median of 30 estimates in a Bloomberg News survey showed.

Policy makers cited weaker retail sales surveys as a signal of slowing economic growth, the minutes of their meeting this month, released yesterday, showed. The fastest inflation in at least a decade prevents the central bank from cutting the main interest rate from the current 5 percent.

Rate Futures

Gilts rose, with the yield on the 10-year government note declining 4 basis points to 4.99 percent, after rising 5 basis points yesterday. The price of the 5 percent security due March 2018 climbed 0.34, or 3.4 pounds per 1,000 pound ($1,986) face amount, to 100.01. The two-year note yield dropped 10 basis points to 4.98 percent. Yields move inversely to bond prices.

The U.K. sold 1.05 billion pounds more of its inflation- protected securities due 2027 today. The returns of the security are linked to the U.K. retail price index.

On the secondary market, the yield on the bonds increased 5 basis points to 1.08 percent, after rising 4 basis points yesterday.

Traders pared bets on higher interest rates, with the implied yield on the December short-sterling futures contract slipping 10 basis points to 5.82 percent. It rose 5 basis points yesterday.

`Peaked'

``Against a backdrop of a weakening economic outlook, we continue to expect a slowdown in retail-sales growth,'' said Grant Lewis, the London-based head of fixed-income research at Daiwa Securities SMBC Europe Ltd. and a former U.K. Treasury official. ``We expect the Monetary Policy Committee to be in a position to cut rates come the fourth quarter, once the slowdown is confirmed by the actual data and inflation has peaked.''

The pound was supported and gilts fell yesterday after the minutes of this month's meeting showed one MPC member voted for the first time in a year to boost interest rates to curb accelerating inflation.

Central bank policy maker Timothy Besley voted to lift rates July 10, saying the fastest inflation in a decade put the central bank's credibility at risk. Seven of his colleagues kept the rate unchanged and David Blanchflower wanted a cut, citing the risk of a sharp slowdown.

U.K. policy makers left the nation's key interest rate unchanged this month after cutting it three times since November in a bid to stave off a recession in the face of accelerating inflation.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net