UK markets scramble to price in 2014 rate rise after Carney warning

* Sterling at five-year highs after BoE (Shenzhen: 000725.SZ - news) rate hike warning

* FTSE 100 closes down 1 pct at 6,777.85 points

* Two-year UK gilt yields soar

* S&P upgrades rating on UK's outlook to stable

* FTSE 100 at lowest level since late April (Updates prices, adds fresh comments)

By Anirban Nag and Sudip Kar-Gupta

LONDON, June 13 (Reuters) - Investors braced on Friday for a UK interest rate hike later this year, pushing sterling to five-year highs and hurting property stocks, after the Bank of England's head said rates may rise sooner than markets expect.

Bank of England Governor Mark Carney's surprisingly stark warning late on Thursday prompted investors to bring forward expectations for a first BoE rate hike by nearly four months, to December from the first quarter of 2015.

"We have a financial system which is on a hair trigger," said Stewart Cowley, an investment director at Old Mutual Global Investors.

Sterling's trade-weighted index hit 5-1/2-year highs and posted its biggest one-day rise in four months.

Shorter-dated British government bond prices plummeted, as the two-year gilt yield soared by the largest amount in more than three years, according to Reuters data.

While sterling rose on the currency markets, Britain's benchmark FTSE 100 equity index fell 1 percent to 6,777.85 points, its lowest close since late April. A stronger pound can hit companies' exports.

Raising rates is also often used to prevent a country's housing market from overheating, and housebuilding and property shares slumped on Friday, with Persimmon (Frankfurt: OHP.F - news) and Barratt Developments falling by 7 and 6.3 percent respectively.

Carney had recently been of the view that rates would be kept lower for longer to ensure a broad-based recovery.

The market now thinks the Bank of England could raise rates at least six months before the U.S. Federal Reserve is expected to tighten policy. That contrasts sharply with the European Central Bank, which cut rates last week and is seen as likely to ease policy in coming months.

"The BoE seems to be slightly ahead of the Fed as far as rate hikes are concerned," said Commerzbank (Xetra: CBK100 - news) currency analyst Lutz Karpowitz.

Economists think British interest rates will start rising in the first quarter of 2015, according to a Reuters poll conducted on Friday, a day after Bank of England Governor Mark Carney said rates may rise sooner than markets expect

UK ELECTION AROUND THE CORNER

Short sterling futures also fell across the strip , pricing in a first hike by December. The sterling overnight interbank average curve (SONIA) was pointing on Friday to a chance of a rate hike by the end of the year, compared with the first quarter of 2015 on Thursday.

Britain's economy is outperforming its peers, growing at a near 3 percent annual rate, and credit rating agency Standard & Poor's on Friday raised its credit outlook on the UK to "stable" from "negative".

However, UK house prices are up 11 percent over the past year, pressuring policymakers to prevent a bubble and Britain faces an election in May 2015 in which living standards and the cost of housing are expected to be major issues.

Sterling hit a fresh 5 1/2-year high in a trade-weighted basket of currencies, rising to 88.2. Britain's recovery has pushed the index 8 percent higher over the past year as investors priced in growing chances of rate hikes by the BoE.

Sterling implied one-month volatility also rose to a six-week high above 5 percent but soon came back down, remaining at less than a quarter of its peaks in 2008.

The euro currency fell to 79.765 pence, its lowest since November 2012. The euro has shed nearly 2 percent since the European Central Bank cut rates last Thursday.

The premium that gilts offer over German Bunds rose markedly, reflecting the diverging outlooks for British and euro zone interest rates.

The yield spread between two-year British and German bonds rose to a session peak of 86.6 basis points, the highest since around late 2008, according to Reuters data.

"These comments should help prompt a sustained move towards higher front-end yields," said Jamie Searle, strategist at Citi. (Additional reporting by Andy Bruce, Patrick Graham and Tricia Wright, Editing by Larry King)