LONDON, June 13 Sterling neared five-year highs against the dollar on Friday and UK stocks fell after the Bank of England chief warned interest rates could rise sooner than markets expected.
Governor Mark Carney's surprisingly stark warning late on Thursday prompted investors to bring forward expectations for a first UK rate hike to before the end of this year, from the first quarter of 2015.
A possible rate hike by the BoE by the end of 2014 would make it the first major central bank to normalise monetary policy since the global financial crisis broke out in 2008.
A hike is likely to be at least six months before the U.S. Federal Reserve is expected to tighten policy and contrasts sharply with the European Central Bank, which cut rates last week and is likely to ease policy in the coming months.
Britain's share index started the day in the red as rate hike expectations hit property stocks while short sterling futures fell across the strip <0#FSS:>, pricing in the first hike by December. The sterling overnight interbank average curve (SONIA) was pointing to a chance of a rate hike by the end of the year, compared with the first quarter of 2015 on Thursday.
"The BoE seems to be slightly ahead of the Fed as far as rate hikes are concerned," said Lutz Karpowitz, currency analyst at Commerzbank. "Macro data is likely to attract particular attention over the coming months. Anything pointing towards a possible rate hike would then support the pound further."
Sterling hit a fresh 5-1/2 year high on a trade-weighted basket of currencies, rising to 88.1. Britain's recovery has pushed the index 8 percent higher over the past year as investors priced in growing chances of rate hikes by the BoE.
The euro fell to 79.87 pence, down 0.2 percent on the day, and its lowest since November 2012. The euro has shed 1.8 percent since the ECB cut interest rates last Thursday.
The diverging policy outlook between the BoE and the ECB has pushed the difference in yields between British and German 10-year government bonds to its widest since 1997.
Against the dollar, the pound was up 0.3 percent at $1.6995 , its highest since May 6 when it hit a high of $1.6997. Above the $1.6997 level, sterling will be at its highest since August 2009 with bulls now targeting the $1.70 mark.
"The pound has maintained its close relationship to the changes in market rate expectations as expressed by the front end of the money market curve. Hence, we would expect the pound to push higher and we maintain our forecast of $1.75," Morgan Stanley said in a morning note. (Additional reporting by Patrick Graham; Editing by Nigel Stephenson and Susan Fenton)