* GBP rises after forecast-busting UK retail sales data
* 10-yr UK gilts yields soar to 2-year high
* SONIA rates inching towards pricing a rate move in 18 months
By Anirban Nag
LONDON, Aug 15 (Reuters) - Sterling hit a two-month high against the dollar while 10-year gilt yields rose to two-year peaks on Thursday after UK retail sales beat forecasts and bolstered expectations of early monetary tightening.
Investors steadily brought forward expectations of a hike in the bank rate, currently at 0.5 percent. Sterling overnight interbank average rates (SONIA)- the very short-term interest rates that form the basis of lending costs to the wider economy - inched towards pricing in a first move in 18 months, compared with two years on Wednesday.
Currently under its "forward guidance" plan, the Bank of England expects to keep rates low until the end of 2016 when it expects the jobless rate to fall to 7 percent. But a steady improvement in data is leading to doubts whether the guidance plan can keep rates anchored for that long.
Retail sales for July rose 1.1 percent from a month earlier, easily beating expectations of a 0.6 percent rise. That comes after a string of recent releases, ranging from rising house prices to a jump in services activity and a brighter prospect for the job market.
Sterling was up 0.5 percent at $1.5585, having hit$1.5591, its highest level since mid-June. The euro was down at 85.23 pence, a 1-1/2 month low, while against a trade-weighted basket, sterling was at 81.40, a seven-week high.
"Consecutive data surprises have pushed sterling higher with the SONIA rates rising and the back-end of the gilt curve steepening," said Adam Myers, head of European FX strategy at Credit Agricole. "Markets are wondering if the BoE forward guidance is backfiring."
The 10-year gilt yield sat at two-year highs of 2.657 percent, according to Reuters data.
The 18-month SONIA rate rose to 0.4965 percent after the retail sales data, from 0.4900 percent beforehand and 0.47125 on Wednesday morning. The two-year SONIA rose to 0.5575 percent from 0.54875 percent beforehand as investors are increasingly pricing in a greater chance of a rate hike in 2015 by the central bank.
Those expectations were bolstered on Wednesday after the jobs report pointed to a brighter outlook and Bank of England minutes showed an unexpected division among policymakers about the guidance plan.
The steady shift in expectations has taken markets' view of the Bank of England rate outlook back to where it was in late June, just before Mark Carney became governor. Soon after taking over on July 1, Carney dampened expectations of an early move by calling a rise in short-term money market rates "unwarranted".
"Tighter financial conditions are the last thing the Bank wants and, as such, we believe that Carney will attempt to verbally push back market pricing over the coming weeks," Morgan Stanley said in a morning note.