By Andy Bruce
LONDON (Reuters) - Investors scaled back their bets that the Bank of England will hike interest rates aggressively after lower-than-expected inflation numbers on Wednesday prompted a huge rally in British government bonds.
Consumer price inflation slowed to 7.9% in June from 8.7% in May, a bigger drop than almost all the economists polled by Reuters had expected. Core and services inflation - closely watched by the BoE - cooled too.
Markets responded in dramatic fashion.
Before Wednesday's data, investors had assigned a roughly 60% chance that the BoE would hike rates on Aug. 3 by a half-percentage point. That turned into a 60% chance of a quarter-percentage point hike after the data.
The predicted peak for Bank Rate was no longer priced in at 6% with the overnight index swap curve showing just as much chance of a 5.75% peak.
Gilt yields dropped sharply, especially for shorter-dated bonds that are most sensitive to the interest rate outlook.
"June's inflation data will make welcome reading for gilts and the BoE alike," Michael Metcalfe, head of macro strategy at State Street (NYSE:STT) Global Markets, said. "But after upside surprises totalling a not-so-cool 1.5% in the past four-months, it will take more than just one month's data to calm rate markets."
The two-year yield was down 27 basis points on the day at 1108 GMT - on track for the biggest daily drop since March 13, when bonds surged after the collapse of Silicon Valley Bank. The yield fell as low as 4.800%, its lowest since June 15.
Yields for longer-dated gilts fell sharply too, with the 10-year yield down 18 bps on the day.
The gap between 10-year gilt and German Bund yields - which had widened sharply in recent months to reflect Britain's more acute inflation problem - narrowed to 185 bps from 199 bps on Tuesday its lowest level in over a month.