Sterling weakens, Carney warns against BOE interference

* Graphic: sterling and gilt yields http://bit.ly/2dgAXn1

* Graphic: sterling year-to-date http://tmsnrt.rs/2egbfVh (Updates, adds details after Carney testimony)

LONDON, Oct (Shenzhen: 000069.SZ - news) 25 (Reuters) - Sterling fell to its lowest since the "flash crash" on October 7, with the Bank of England Governor Mark Carney warning investors would demand a higher premium to buy British assets, if the central bank's independence was questioned.

Carney appeared at the House of Lords Economic Committee to discuss the economic consequences of the Brexit vote.

His testimony comes at a time when relations between the BOE (Shenzhen: 200725.SZ - news) and the government appear tense after Prime Minister Theresa May warned that quantitative easing was having an adverse effect on savers and pensioners. Carney hit back saying he will not "take instruction" over policy.

Carney told lawmakers it was up to the government to set the BoE a target for ensuring price stability which the Bank's policymakers then decide how to meet.

"That process is the process that the BoE is following and if it were to be called into question, one would expect to see the emergence of a risk premium around a range of UK assets, it would be most prominent around the currency, in gilt markets, in inflation expectations," he said.

Sterling shed 1.2 percent to $1.2082, its lowest since Oct. 7, but recovered to trade at $1.2160, still down 0.6 percent on the day. The euro was also up 0.7 percent at 89.45, having risen at one point to 89.805 pence.

Traders said the pound's partial recovery was after Carney said the exchange rate's drop would have to be taken into account for policy consideration.

Investors have priced out chances of a near-term rate cut from the BOE, given the steep drop in the pound in the past few weeks. The drop has stoked inflationary pressures and driven investors to sell gilts.

"The bounce was driven by receding expectations of a cut next week," said Tobias Davis, head of corporate treasury sales at Western Union, adding in the short term, sterling's outlook remained rather grim.

In the past few weeks as politics took centre stage, concerns about a "hard" Brexit by Britain and a tough stance by the European Union in the negotiations that are likely to start next year gave sterling a battering.

This week, though, the focus will be on third-quarter growth readings for the economy due to be released on Thursday.

After a strong second quarter, Britain's economy is expected to slow to 0.3 percent growth in the third quarter.

The report will be the first reading of how the broad economy has performed in the immediate aftermath of the vote to leave the EU in June. So far, all the evidence has suggested that the economy has held up well and the country is likely to dodge a recession.

Nevertheless, the currency has shed nearly 18 percent against the dollar since the June vote with losses accelerating in October after May raised the spectre of a "hard" Brexit.

Under a hard Brexit the government will negotiate for an exit that favours tighter immigration controls over free trade, likely curbing foreign investment needed to fund Britain's huge current account deficit. (Reporting by Anirban Nag; Editing by Robin Pomeroy)