By Andy Bruce
LONDON (Reuters) - Investors bet on a slightly quicker pace of Bank of England rate hikes on Wednesday, encouraged by signs the United States is on track for a rate hike in September, a day before a major BoE policy meeting.
Gilt yields opened sharply higher after comments overnight from top U.S. Federal Reserve official Dennis Lockhart, who said growth in the world's biggest economy was on track for him to vote for higher interest rates in September.
Most economists believe the BoE is unlikely to raise interest rates from record-low levels before the U.S. Federal Reserve acts.
While some underwhelming U.S. jobs data tempered yield rises in the middle of the day, two-year gilt yields (GB2YT=RR) shot up to their highest level since June 26 at 0.689 percent on news that U.S. service sector growth surged to a 10-year high.
They were last at 0.66 percent, up 7 basis points on the day. Five- (GB5YT=RR) and 10-year (GB10YT=RR) gilt yields each shot up around 10 basis points on the day, following German Bund
Short sterling interest futures <0#FSS:> fell sharply, especially for 2016 contracts and further out, indicating a steeper path of expected British interest rate hikes.
Gilts showed little reaction to a slightly weaker-than-forecast survey of British businesses in the services sector.
The BoE is likely to say on Thursday that its top policymakers are split over the need to raise interest rates, adding to expectations that the central bank is heading for its first increase in borrowing costs in nearly a decade.
Economists polled by Reuters expect a seven-to-two split among BoE rate-setters, but clues that more members are on the cusp of voting for higher interest rates would leave short-dated bonds vulnerable, said Jason Simpson, rates strategist at Societe Generale (PARIS:SOGN).
The market currently prices in a first BoE rate hike around April.
"Even with the sell-off today, we're not fully pricing in a February rate hike yet, which is our central call. I do think there is some room for yields at the very front end to back up further, for sure," he said.
While the market currently prices in around a 35 percent chance of a rate hike this November, that could easily move to a 50-50 call if three members of the Monetary Policy Committee vote for a rate hike, Simpson added.
The premium that 10-year gilts offer over the equivalent German Bund collapsed to 121.9 basis points, the lowest level since July 13, as gilts outperformed plunging Bund prices.