Pound, UK borrowing costs drop as investors up bets on rate cuts after dovish...

Impact of Bank of England's Decision

By Lucy Raitano

Market Reactions to Rate Cut Expectations

LONDON, Feb 5 (Reuters) - Sterling and UK government borrowing costs fell on Thursday, as investors quickly priced in a much higher chance of a near-term rate cut, after the Bank of England said it expected a future cut if inflation continued to slow.  

Inflation Forecast and Economic Outlook

The decision to keep the bank rate at 3.75% was in line with expectations but the 5-4 vote split was a closer call, with an earlier Reuters poll having pointed to 7-2 vote split.

Political Factors Influencing Sterling

"The vote split is a lot more dovish than expected. It's what markets are reacting to," said Kirstine Kundby-Nielsen, analyst at Danske Bank.

The pound extended losses and hit a near two-week low against the dollar after the decision, and was last down 0.6% at $1.358..

"A low inflation forecast has contributed towards easing some members’ concerns about inflation persistence," said Philip Shaw, chief economist at Investec.

"Our forecast has been that the MPC would keep rates on hold until the end of April, but we wouldn’t be surprised if that cut is brought forward," he said.

UK short-dated two-year gilt yields - which reflect short-term interest rate expectations - headed for their biggest one-day drop since last April, as bond prices rallied, dropping  9 basis points on the day to a three-week low of 3.63%. 

After the BoE decision traders were pricing in nearly 50 bps of rate cuts by year-end, implying two more quarter-point reductions. This is up from 35 bps by year-end just before the BoE decision.

"They have tweaked the cautious easing guidance by scrapping reference to a gradual downward path of the bank rate," said Elias Haddad, senior markets strategist at Brown Brothers Harriman.

The BoE has also slashed its inflation forecast to 1.7% - below its 2% target - and said it expects inflation to slide to reach that target in April, much sooner than in its early November forecast.

UK 10-year gilt yields dipped 2 bps to 4.53%.

The blue-chip UK FTSE 100 initially pared some earlier losses after the decision, but was last down 0.4%

Sterling was weak during morning trading amid growing pressure on UK Prime Minister Keir Starmer over former U.S. ambassador Peter Mandelson's ties to the late U.S. sex offender Jeffrey Epstein.

"We've got twin problems for sterling today, obviously, with more rate cuts being priced and all the political risks," said Jeremy Stretch, head of G10 FX Strategy at CIBC Capital Markets.

(Reporting by Lucy Raitano and London markets team; Editing by Amanda Cooper)