By Amanda Cooper
LONDON (Reuters) - The pound fell on Friday, heading for its largest weekly loss in over a month on rising expectations the UK economy could slip into recession after the Bank of England delivered an outsized rate hike in response to persistent inflation.
The BoE on Thursday raised interest rates to their highest level since 2008, with a half-point hike that markets had anticipated, but that caught a number of investors off guard.
Money markets show UK rates could peak as high as 6% by the end of this year and stay there for another six months, given how entrenched inflation is becoming in the broader economy.
Meanwhile, a key market-based gauge of confidence in the economy fell to its weakest since early 2000, reflecting how investors are upping their bets on the UK succumbing to recession.
Sterling fell by as much as 0.5% on the day against the dollar to a low of $1.2685. It later recovered to trade down 0.4% at $1.2702, but was set for a weekly loss of nearly 1%, its largest since mid-May.
"What has been interesting has been the pound's reaction. Normally, a G10 major central bank going for a jumbo rate hike, you'd expect a jump in sterling. But that fact that it's come off is just a reflection of those fears," City Index markets strategist Fiona Cincotta said.
"Fears of a recession are going to ramp up from now on and that is going to limit sterling's potential, especially when you've got Fed Chair (Jerome) Powell sounding hawkish as well, so there isn't going to be any respite coming from a weaker dollar."
The pound fared more strongly against other currencies, rising 0.6% against the euro to 85.47 pence after data showed a surprise deterioration in euro zone business activity that could dampen expectations for the European Central Bank to keep raising rates.
Sterling was down 0.4% against the yen at 181.6 yen, having hit its highest since late 2015 against the Japanese currency this week.
Data earlier on Friday showed British retail sales unexpectedly rose in May, boosted by an extra bank holiday to mark the coronation of King Charles, but also suggesting most consumers were - for now - coping with high inflation's squeeze on their spending power.
The resilience of Britain's labour market has been another factor that has given the BoE very little room to relax its drive to bring inflation back towards its 2% target.
Analysts have said many consumers won't feel the full impact of a string of rate rises yet because a high percentage of homeowners in Britain are on fixed-rate mortgages and will be sheltered from higher borrowing costs for longer.
A separate purchasing managers' (PMI) survey on Friday showed Britain's economy showed signs of slowdown this month, as inflation ran high.
Chris Williamson, chief business economist at S&P Global Market Intelligence, said the PMI survey suggested the economy had lost momentum after a brief growth spurt in the spring and looked set to weaken further in the months ahead.
"Most notably, consumer spending on services, which was a core growth driver in the spring, is now showing signs of faltering," he said.