U.K. Pound Falls to One-Week Low Against Euro on Slower Growth

By Lukanyo Mnyanda

Aug. 22 (Bloomberg) -- The U.K. pound fell to the lowest level in a week against the euro after a government report showed economic growth stagnated in the second-quarter, strengthening the case for lower interest rates.

The pound also headed for a fifth week of losses against the dollar, the longest losing streak since February 2006, as the Office for National Statistics said U.K. gross domestic product was unchanged from the previous three months. Inflation risks ``have probably eased a little,'' the minutes of the Bank of England's August rate meeting showed this week.

``This is a pretty toxic environment for the pound,'' said Lee Hardman, a currency strategist in London at the Bank of Tokyo-Mitsubishi Ltd. ``There's a risk of a rate cut in November if the data continues to deteriorate.''

The U.K. currency dropped as much as 0.7 percent to 79.89 pence per euro, the lowest level since Aug. 14, and was at 79.74 by 1:36 p.m. in London, from 79.32 yesterday and 78.70 a week ago. It dropped more than 1 percent to $1.8603, from $1.8782 yesterday. The pound may drop below $1.80 in 12 months, Hardman forecast.

Gross domestic product was unchanged from the first quarter, the Office for National Statistics said, compared with a previous estimate for growth of 0.2 percent. Economists had expected a 0.1 percent expansion, according to the median estimate of 34 economists in a Bloomberg News survey. Growth was 1.4 percent from a year earlier, the weakest since 1992.

The report adds to pressure on the Bank of England to set aside concerns about inflation and cut its benchmark interest rate, currently at 5 percent.

`Support the Market'

Deutsche Bank AG changed its U.K. interest-rate forecast yesterday and said the central bank will lower borrowing costs by 1 percentage point next year. The benchmark rate will be cut to 4 percent in the first three quarters of 2009, George Buckley, the bank's chief U.K. economist, wrote in an e-mailed note.

``The prime focus remains how soon does inflation come off,'' said Simon Derrick, a currency strategist in London at Bank of New York Mellon Corp. ``And how soon can the Bank of England move to get monetary policy down to a level that will help support the market.''

Gilts rose, with the yield on the 10-year bond falling 1 basis point to 4.56 percent. The price of the 5 percent security due March 2018 rose 0.07, or 70 pence per 1,000-pound face amount, to 103.35. The yield on the two-year gilt, which is more sensitive to interest rate changes, fell 1 basis point to 4.57 percent. Bond yields move inversely to prices.

Economy Falters

The U.K. economy faltered after banks choked off credit following the collapse of the U.S. subprime mortgage market. Still, an inflation rate at more than twice its 2 percent target has prevented the Bank of England's from cutting interest rates to revive the economy.

``It's a disappointing outturn,'' said Ross Walker, an economist at Royal Bank of Scotland Group Plc, the U.K.'s second largest lender, in a Bloomberg Television interview. ``It raises the risk of an earlier cut in interest rates.''

Morgan Stanley recommended yesterday investors put on trades that benefit from a drop in the pound against the Australian dollar and Swiss franc on speculation the economic slowdown in the U.K. will deepen.

Investors should enter the so-called short positions at 2.1360 Australian dollars per pound and target a decline in the British currency to 2.0400, Sophia Drossos, a New York-based strategist, wrote in a client note. They should also hold on to so-called short positions on the pound versus the franc, with a target of 1.95, she wrote. A short position is a bet the value of a currency or security will fall.

Spreads Narrow

U.K. bonds have outperformed their European counterparts in the past three months as evidence the economic slowdown is deepening persuaded investors to remove wagers on rate increases. The implied yield on the March short-sterling futures contract was at 5.26 percent. It has declined from 5.44 percent at the end of July.

The spread between U.K. government bonds and their German counterparts has narrowed. The 10-year gilt yielded 38 basis points more than the German bund, the smallest gap since July 22. It was at 69 basis points on Feb. 25, the widest this year.

U.K. bonds have returned 4.3 percent in the past two months, compared with 2.9 percent for their European counterparts, according to Merrill Lynch & Co.'s EMU Direct Government and U.K. Gilts Master indexes.

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