Stocks and bonds rally, sterling hits lowest level since May

British annual consumer price inflation dropped to 6.7% last month

Sterling dropped to its lowest since late May, while UK government bonds and stocks soared on Wednesday as figures showing inflation slowed more than expected in August raised the possibility that the Bank of England could pause rate hikes this week.

British annual consumer price inflation dropped to 6.7% last month. Economists polled by Reuters had predicted Consumer Price Index would rise to 7.0% from July's 6.8% after a rise in fuel prices and an increase in a tax on alcoholic drinks.

Sterling was last 0.23% lower on the day at $1.2363, having dropped to $1.2334 soon after the data, its lowest since May 30.

That decline came as investors scrambled to reel in bets that the Bank of England will hike interest rates again on Thursday.

Traders think there is a 60% possibility the Bank leaves rates unchanged, up from 20% on Tuesday, according to pricing in derivatives markets.

They now see a 40% likelihood of a 25-bps rise to 5.5%, an outcome which was priced as a near-certainty just a month back.

In bond markets, interest rate-sensitive two-year gilt yields shed 14 basis points to 4.86% as investors rushed into British bonds, putting it on track for the biggest daily decline since August 23. Yields move inversely to prices.

The benchmark 10-year Gilt yield was last down 9 basis points at 4.254%. It earlier dropped to 4.239%, the lowest since late July.

Goldman Sachs added to a bullish feeling in UK bond and equity markets after it said it now thinks the Bank of England is already finished raising rates.

Britain's FTSE 100 stock index was last up 0.8% and the FTSE 250 index of mid-sized companies was up 1.44%. Both were surpassing the 0.63% increase in the pan-European STOXX 600 gauge.

The August inflation data surprised meaningfully to the downside, especially on core and services inflation, Goldman economists, led by Sven Jari Stehn, said in a research note.

Along with their recent dovish commentary, we now expect the Monetary Policy Committee to keep Bank Rate unchanged tomorrow and lower our forecast for the terminal policy rate to 5.25% (from 5.5% before), Goldman's team said.

Core inflation slowed sharply to 6.2% YOY from 6.9% in July. The measure does not include volatile food and energy prices and policymakers and investors see it as a guide to key price pressures.

Many experts said they still expected one final raise on Thursday, however.

CPI is still running well over three times its 2% target and Britain has the highest rate of inflation among major economies.

It remains our house view that a rate raise is likely, though definitely the odds that a pause will follow have risen, said Jane Foley, senior FX strategist at Rabobank.

She added that the pound could even get some support from investors now that inflation is slowing faster than expected, a positive outcome for the UK economy.