Sterling hits highest since October 2008 as BoE and Fed diverge

By Jemima Kelly

LONDON, June 19 (Reuters) - Sterling extended gains above $1.70 to hit a 5-1/2 year high against the dollar on Thursday, bolstered by the diverging monetary policy outlooks between the Bank of England and the U.S. Federal Reserve.

Britain's pound was also helped by robust data. A measure from the Confederation of British Industry showed factory orders grew at their fastest pace in six months in June, far outstripping expectations.

The yield gap between two-year British gilts and U.S. Treasuries widened, prompting more investors to buy sterling.

While the Federal Reserve signalled on Wednesday that rising inflation won't trigger an increase in U.S. interest rates any time soon, investors are pricing in the chance of a rate hike in Britain before the end of the year.

Sterling rose to $1.7052, up 0.3 percent on the day. The pound also rose against the euro, with the single currency down slightly at 79.96 pence. The currency barely reacted to monthly UK retail sales data for May which showed a fall for the first time since January.

On a year-on-year basis, retail sales were slightly below forecasts but that did little to alter rate hike expectations.

"These slightly worse-than-expected figures shouldn't affect the optimistic outlook for the UK economy as there was always going to be a slight drop given the unexpectedly high April reading," said Jake Trask, corporate dealer at UKForex.

Sterling has gained more than 10 percent in the past year on expectations a rapidly improving UK economy would prompt the BoE (Shenzhen: 000725.SZ - news) to raise rates before its peers in Europe and the United States. The rally had stalled in the past month after Governor Mark Carney warned markets in mid-May not to expect swift action.

But he surprised investors last week by saying rates might rise before many were predicting, prompting investors to bring forward expectations for a hike to later this year from the first quarter of 2015.

In line with Carney's comments, the minutes from the Bank of England's last meeting said the nine members of the policy committee were surprised that markets had priced in a relatively low chance of an interest rate rise in 2014.

On Thursday BoE policymaker Ian McCafferty said that data over the next few months will have a critical influence on when the central bank raises rates.

While the BoE is preparing markets for a rate hike, Fed chair Janet Yellen indicated on Wednesday that monetary policy in the United States was unlikely to tighten anytime soon. That should boost the pound against the dollar in the coming weeks.

"Some may have expected the Fed turning a bit more hawkish, because inflation was higher, because of the BoE making a case of higher rates, but no, that did not happen," said Manuel Oliveri, FX strategist at Credit Agricole (TLO: ACA.TI - news) .

"Yellen did not really make a big point of rate increases ... She's downplaying inflation risk. There is more room for diverging Fed/BoE monetary policy expectations and for rate differentials to rise because the Fed is keeping rates more or less capped."

In the gilts market, the 10-year yield spread between British and German government bonds rose as far as 140.9 basis points - its highest since 1997.

They were last up 3 basis points on the day at 140 basis points as German Bunds outperformed their British counterparts. (Additional reporting by Anirban Nag and Ana Nicolaci da Costa; Editing by Sonya Hepinstall)