UK bond yields sink, sterling steadies after Fed stays on hold

(Recasts with dollar recovery)

By David Milliken and Patrick Graham

LONDON, Sept 18 (Reuters) - British financial markets scaled back expectations for the Bank of England to tighten monetary policy on Friday after the U.S (Other OTC: UBGXF - news) . Federal Reserve backed away from raising interest rates, pushing bond prices higher and reducing the cost of short-term credit.

Stock markets went the other way, worrying over what the U.S. central bank's reluctance to move said about global growth. The pound recovered ground along with the dollar against the euro in afternoon trade to stand half a percent higher.

"I think it changes the burden of proof for the Bank of England now," said Rob Wood, chief UK economist at Bank of America Merrill Lynch.

"For me it was already a close call for the BoE between February and May. If the Fed delays until December or even longer, that really matters for the BoE (as) they are ultimately worried about the same thing, world growth."

British government bonds chalked up their strongest one-day gains since early July, when Greece was scrambling for fresh aid from creditors.

Ten-year gilt yields fell 11 basis points to 1.85 percent, while two-year yields hit their lowest since Aug. 24 at 0.579 percent before recovering to 0.62 percent.

Short sterling rate futures, a proxy for interest rate expectations, also rallied sharply, with March 2016 contracts up 5 ticks on the day at 99.28.

Dealers said sterling was initially caught between the negative impact of the Fed meeting on expectations for interest rates next year and the resulting falls for the dollar.

But the dollar recovered strongly in afternoon trade in London after U.S. markets opened, pulling sterling with it, against the euro. A speech by Bank of England chief economist Andy Haldane, warning that its next move may be a cut rather than a rise in rates, had relatively limited impact.

The pound was half a percent higher at 73.02 pence per euro and roughly steady at $1.5574.

"Haldane is definitely the most dovish on the monetary policy committee and the market within that context discounts what he says," said Sam Lynton-Brown, a strategist with BNP (Paris: FR0000131104 - news) Paribas in London. "If this was Governor Carney perhaps there would have been a bigger reaction."

In a note to clients on Friday, economists at U.S. bank Citigroup (NYSE: C - news) pushed back their expectations for a rise in Bank of England rates until the fourth quarter of next year.

"Modest UK growth, plus the disinflationary pressures from the strong pound and weak external costs, reinforces the likelihood of a further long period of low-flation," they said.

Dec long gilt future 118.18 (+0.97)

Dec 2015 short sterling 99.37 (+0.03)

June 2016 short sterling 99.17 (-0.06)

10-year yield 1.85 pct (-11 bps)

-------------------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-------------------------- Gilts Sterling Euro Debt Dollar U.S. Treasuries Debt reports --------------------GILT STRIPS DATA ------------------------- Gilt strips data All gilt strips Gilt strips IO Gilt strips PO (Reporting by David Milliken; Editing by Andrew Heavens)