(Updates prices, adds fresh comments)
By Anirban Nag and Tricia Wright
LONDON, June 13 Investors braced on Friday for a UK interest rate hike later this year, pushing sterling to five-year highs and hurting property stocks, after the head of the Bank of England said rates may rise sooner than markets predict.
Governor Mark Carney's surprisingly stark warning late on Thursday prompted investors to bring forward expectations for a first BoE rate hike by nearly four months, to December from the first quarter of 2015.
Sterling's trade-weighted index posted its biggest one-day rise in four months, hitting 5 1/2-year highs. Short-dated UK government bond yields were on track for their biggest daily gain in more than three years.
A rate hike by the end of 2014 is likely to come at least six months before the U.S. Federal Reserve tightens policy. It would contrast sharply with the European Central Bank, which cut rates last week and is likely to ease policy in the coming months.
"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."
Short sterling futures fell across the strip <0#FSS:>, pricing in a 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.
Carney also said he was concerned by signs that mortgage lending standards were becoming looser and set out the case for early action as insurance against future risks.
While Britain's economy is outperforming its peers, growing at a near 3 percent annual rate, house prices are up 11 percent over the past year, pressuring policymakers to prevent a bubble. Britain faces an election in May 2015 in which living standards and the cost of housing are expected to be major issues.
The comments from Carney, who until recently was of the view that rates would be kept lower for longer to ensure a broad-based recovery, sent London's main share index down 1 percent, with housebuilders Persimmon and Barratt Developments both losing between 6-7 percent.
Sterling hit a fresh 5 1/2-year high in a trade-weighted basket of currencies, rising to 88.2. 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 79.765 pence, its lowest since November 2012. The euro has shed nearly 2 percent since the ECB cut rates last Thursday.
The diverging UK and European policy outlooks have pushed the difference in yields between British and German 10-year government bonds to its widest since 1997.
The pound hit $1.6995, its highest since reaching $1.6997 on May 6. Above $1.6997, sterling will be at its highest since August 2009, with bulls now targeting the $1.70 mark.
STOCKS HIT, YIELDS RISE
Analysts were relatively sanguine on housebuilding stocks, saying Friday's falls should be seen in the context of strong gains in the share prices. While higher rates would raise the costs of borrowing to build, it would also signal the economy - and consequently funding prospects - were looking brighter.
"Markets are obviously now anticipating that interest rates will rise - it'll just take some of the froth off the strength that we've seen (from housebuilders)," said Richard Hunter, head of equities at Hargreaves Lansdown.
The pain was felt throughout the property sector, with Land Securities and British Land both falling 2.8 percent.
In the gilts market, shorter-dated British government bond prices plummeted, with the two-year gilt yield on course for its biggest daily gain in more than three years, according to Reuters data.
It was last up some 15 basis points at 0.888 percent, having hit a high of 0.903 percent - its highest since mid-2011.
"These comments should help prompt a sustained move towards higher front-end yields," said Jamie Searle, strategist at Citi.
(Additional reporting by Andy Bruce, Editing by Larry King)