UK government bonds surge on gloomy BoE growth view

LONDON (Reuters) - Short-dated British government bond prices surged on Thursday as investors judged that the Bank of England's gloomy economic growth outlook would slow the pace of interest rate rises, despite inflation being set to reach double figures.

The BoE raised interest rates to 1% from 0.75%, predicted inflation would exceed 10% in the final three months of this year, and forecast the economy would contract in the final quarter of 2022 and over 2023 as a whole.

"It is a very weak projection, a very sharp slowdown," BoE Governor Andrew Bailey told reporters.

Two-year gilt yields are on course to drop 8 basis points on the day to 1.58% and earlier in the day they touched a one-month low of 1.418%, according to Refinitiv data.

Ten-year gilt yields were flat on the day at 1.98%, while 30-year yields were 4 basis points higher at 2.14%.

BoE policymakers are split on the outlook for rates.

While a minority of three officials wanted to raise rates by 50 basis points rather than 25 basis points this month, two others were unhappy with BoE language saying further tightening might be needed.

Interest rate futures show investors see an 89% chance that the BoE will raise interest rates to 1.25% next month but expectations for December fell off slightly, with the question being whether rates will reach 2.25% rather than 2.5%.

The BoE is also making no immediate move on active sales from its 847 billion-pound ($1.05 trillion) gilt portfolio. BoE staff will report on the plan to the Monetary Policy Committee in August with a policy decision due at a later meeting.

U.S. bank Citi said it saw further scope for short-dated gilts to rally and it expected 10-year yields to stabilise in a range of 1.6% to 2% after selling off sharply earlier this year.

"The fact that some (MPC) members didn't support the guidance for further hikes appears to have awoken the market to the clearer message that terminal rate pricing is way too high," Citi said.

The BoE's cautious tone contrasts with the U.S. Federal Reserve, whose chair Jay Powell said on Wednesday that 50 basis-point rate rises remained on the table, given the strength of the U.S. economy.

Ten-year U.S. Treasury yields rose to their highest relative to 10-year gilts since January 2020, with a spread of 112 basis points, 15 basis points wider on the day.

($1 = 0.8091 pounds)

(Reporting by David Milliken; Editing by William Schomberg)