Economic worries hit world stocks, sterling

LONDON (Reuters) - Investors cut back on risky assets on Wednesday, dumping stocks and high-yielding currencies on global credit and economic worries while they pushed sterling to a 11-1/2 year low after a Bank of England inflation report.

Wednesday's data provided fresh evidence that U.S. economic problems are spilling over to the rest of the world. Japan's economy contracted in the second quarter at the sharpest rate in seven years, reinforcing the view that the world's No. 2 economy has slipped into recession.

In the quarterly report which highlighted the possibility of a UK recession, the BoE said domestic inflation will fall below its 2 percent target in two years and warned that growth risks remained on the downside.

"The tone is clearly dovish, with the economy now expected broadly to stagnate over the next year or so," said Jonathan Loynes, chief European economist at Capital Economics.

"Against that background, we stick to the view that interest rates will eventually fall very sharply once inflation pressures finally recede. Market rate expectations therefore have scope to fall much further in time."

Sterling fell as low as $1.8737 while it hit a 11-1/2 year low on the trade-weighted index.

The MSCI main world equity index fell 0.7 percent while emerging stocks fell to a one-year low of 975.37.

The FTSEurofirst 300 index fell more than 1 percent. U.S. stock futures fell 0.2 percent, pointing to a weak open on Wall Street.

News that JPMorgan has racked up $1.5 billion of losses so far this quarter on mortgage-linked assets and an outlook warning from Commonwealth Bank of Australia reminded investors that the fallout from the year-old credit crisis is far from over.

HIGH-YIELDING VICTIMS

The New Zealand dollar, which boasts the highest interest rate in the industrialized world, fell 2 percent to a two-year low near 74 yen while the Aussie also fell 2 percent to a four-month low near 93 yen.

The two currencies have been under pressure as expectations intensify that falling commodity prices will encourage central banks there to cut interest rates.

"With real policy rates in the region set to fall, both economies are likely to see a more protracted spell of high inflation, a risk that will be exacerbated if the trade term gains over the past years are to reverse course going forward," Simon Wong, economist at Standard Chartered, said in a note.

"Another challenge will come from potential adjustments in external balance in reaction to lower real returns on the region's financial assets that could undermine the supply of foreign funding to the domestic financial sectors."

The dollar was down 0.3 percent against a basket of major currencies, after hitting a six-month high on Tuesday.

Emerging sovereign spreads widened 1 basis point.

The September Bund future rose 23 ticks on concerns over the economy.

U.S. light crude steadied at $112.99 a barrel, having fallen more than $30 from its record peak in July. Gold rose to $815.55 an ounce after hitting an eight-month low on Tuesday.

(Editing by Ron Askew)