* Sterling hits 2-1/2 year low vs dollar after downgrade
* QE prospects help gilts recover from big initial fall
* Markets see risk of further sterling and gilt weakness
By David Milliken
LONDON, Feb 25 (Reuters) - Britain's loss of its top credit
ranking from Moody's added to the pound's weakness on Monday,
helping send it lower against both the dollar and euro, but UK
bonds, underpinned by the central bank, recovered quickly.
The pound only fell moderately, but still hit lows against
the dollar not seen since July 2010. The euro rose
against sterling to its highest since October 2011.
Ten-year British bonds, known as gilts, initially sold off
sharply but later closed flat, attracting interest from
investors worried about the outcome of Italy's elections.
British shares were broadly higher, lifted in many cases by
prospects of stronger exports from a weaker currency.
Moody's became the first major ratings agency to downgrade
British debt late on Friday, surprising some in the markets with
its timing, but reflecting a broad view that a weak economy will
impede British efforts to reduce its deficits.
Nonetheless, the move was an embarrassment for Britain's
finance minister George Osborne, who promised in the past to
protect Britain's AAA credit rating.
"The credit rating is an important benchmark for any country
but this government's economic policy is tested day in and day
out in the market, and it has not been found wanting today,"
Osborne told parliament.
The main spokesman for finance in the opposition Labour
Party, Ed Balls, told Osborne to "get out of denial and get a
new plan that will actually work on growth, jobs and the
deficit. Or else the prime minister will have to get a new
Earlier, a spokesman for Prime Minister David Cameron echoed
Osborne's comments that the government would stick to its plan
to cut the budget deficit and public debt.
The impact of the downgrade was relatively muted in markets
because investors have already been reacting to the conditions
that prompted Moody's to act - particularly an economy teetering
on the brink of a third recession in four years.
The pound came under heavy selling pressure last week after
the Bank of England made clear that the currency could have
further to fall, and that it is prepared to tolerate the impact
this would have on inflation.
Bank of England Governor Mervyn King's support for more bond
buying, or quantitative easing (QE), has also weighed on
sterling because it implies more potential money printing.
"Realistically this is not a sudden smash down but a
continuation of a (market) move that's been under way all year,"
Andy Chaytor, London-based macro strategist at Nomura.
"The stars have aligned in terms of fiscal policy, central
bank policy - being seen by the market to be allowing higher
inflation - and then you get a downgrade as well," he said.
Sterling hit its two-and-a-half year low of $1.5073 during
Asian trading hours, before recovering to $1.515. It fell to a
16-month low against the euro of 88.15 pence and then recovered
as uncertainty about the Italian elections weighed on the euro.
The pound was around 7 percent weaker against both the
dollar and the euro than it was at the start of the year.
GILTS RECOVER LOSSES
In government debt markets, 10-year gilt yields
jumped at the start of trading by 6 basis points to peak at
2.175 percent - their sharpest intraday price fall since Feb.
13. Later they ended the session flat at 2.11 percent.
more bond purchases has helped gilts, even if the inflation
outlook makes some investors think they offer poor value.
Last week's central bank minutes "gave the market a
life-line," Chaytor said. "If we hadn't had that, things might
have been a bit rockier."
Some investors said Osborne should not draw too much comfort
from the muted initial reaction in markets.
"The government has favourably contrasted (Britain's) low
government bond yields with high yields in a number of euro zone
countries ... But this comparison is disingenuous," said Toby
Nangle, a fund manager at Threadneedle Investments.
"Yields are low because the market believes that (interest)
rates will remain low, and because of the Bank of England's
policy of quantitative easing," he added.
The next test of investor sentiment will come later this
week, and possibly as early as Tuesday, with a sale via
syndication of around 3.8 billion pounds ($5.7 billion) of 2052
* March gilt future 116.11 (+0.05)
* March short sterling 99.49 (-0.01)
* June short sterling 99.50 (-0.01)
* 10-year yield 2.11 percent (UNCH)
--------------------- KEY MARKET DATA---------------------------
Long Gilt futures Gilt benchmark chain
Short Stg futures Cash market quotes
Deposit rates Sterling cross rates
UK debt speedguide
--------------------KEY MARKET REPORTS--------------------------
Euro Debt Dollar
U.S. Treasuries Debt reports
-------------------- GILT STRIPS DATA --------------------------
Gilt strips data All gilt strips
Gilt strips IO Gilt strips PO
A list of all the strippable British gilts