UK rate path flattens before BoE meeting, after poor U.S. data

LONDON, July 31 (Reuters) - Gilt prices soared on Friday as a slowdown in U.S. employment costs prompted investors to bet on a slower pace of Bank of England interest rate increases in coming years, just days before the central bank holds a major policy meeting.

Most economists believe the Bank of England is unlikely to raise interest rates from record low levels before the U.S. Federal Reserve acts.

Friday's figures argued against expectations the Fed will raise rates in September - U.S. labour costs recorded their smallest increase in 33 years during the second quarter.

U.S. and British government bond yields tumbled and short sterling interest rate futures rose strongly, especially for late-2016 contracts and further out, indicating a shallower path of expected British interest rate hikes.

Five- and 10-year gilt yields were last down around 9 basis points on the day, the latter touching its lowest level since July 8 at 1.877 percent.

The benchmark 30-year gilt yield bottomed out at 2.558 percent, its lowest level since June 1. It was last down 7 basis points on the day.

Financial markets now indicate the Bank of England willl first raise rates hike from 0.5 percent taking place around May 2016, compared with only two weeks ago when they pointed to the first quarter of next year.

Despite the poor U.S. data, some BoE watchers think its policymakers will focus more on the domestic inflation in its August policy decision on Thursday, which will include the release of minutes from the meeting and quarterly economic forecasts.

They could contain a more hawkish bias than the market expects, said RBC (Other OTC: RBCI - news) rates strategist Vatsala Datta, who predicts the BoE will raise rates in November - sooner than the consensus from Reuters polls for February.

It is conceivable that three out of the nine members on the Monetary Policy Committee will break ranks and vote for an rate hike, rather than two, as many in the market expect, said Datta.

With the market having pushed back expectations for a rate move over the past couple of weeks, the risk of a sharp correction exists if the BoE bumps up its projections for inflation in two years' time, and by extension the path for interest rates.

"I think the risk-reward is definitely to be on the short-side in the front end," said Datta.

Friday's repricing of British rate expectations prompted a dramatic narrowing of the premium that 10-year gilts offer over German Bunds of the same maturity. It was last down almost 9 basis points on the day at 123 basis points -- the sharpest narrowing of the spread since early June.

Sept long gilt future 117.30 (+0.86)

Sept 2015 short sterling 99.39 (+0.02)

March 2016 short sterling 99.18 (+0.05)

10-year yield 1.88 pct (-9 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 Andy Bruce, editing by Larry King)