Dovish BoE dents buoyant sterling but soothes battered gilts

*

BoE holds rates but policy split widens

*

February rate cut now looks more likely - analysts

*

Short-dated gilts win reprieve from dovish tone

(Updates throughout)

By Harry Robertson and Naomi Rovnick

LONDON, Dec 19 (Reuters) - A dovish message from the Bank of England on Thursday dented the outlook for sterling, one of the year's best performing major currencies against the dollar, while bringing a reprieve to Britain's battered government bond markets.

The pound slipped and two-year gilt yields pulled back from seven-month peaks after the BoE held its key interest rate at 4.75%, as expected, but three policymakers voted to lower borrowing costs.

Analysts said the surprise vote split highlighted the risks of British interest rates falling faster than anticipated next year - a development that could weigh on sterling but shore up bond markets.

Data this week showed growth in British wages sped up in the three months to October and inflation rose to an eight-month high of 2.6% in November, seemingly cementing the case for the BoE to lower rates only gradually next year.

Yet growth has stalled. Britain's economy shrank for a second month in a row in October.

"The Bank of England will follow the ECB in 2025. They can easily afford to lower rates progressively," said Florian Ielpo, head of macro at Lombard Odier in Geneva, referring to the European Central Bank.

"We're in dire need of a recalibration of monetary policy because policy globally, the level of risk-aversion, is more consistent with the inflation we had two years ago than the inflation we have at the moment."

The pound was last up 0.3% at $1.2611, having risen as much as 0.7% earlier in the day, as it recovered from a sharp drop in the previous session when a hawkish tone from the U.S. Federal Reserve sent the dollar surging.

It has fallen around 0.9% against the dollar since January but remains one of the strongest major currencies this year.

The euro was up around 0.2% at 82.48 pence - pulling back from around its lowest levels against sterling since March 2022, which is within striking distance of levels seen in June 2016.

BOND REPRIEVE?

Signs of a shift among British rate setters went down well with bond investors, who have pushed up gilt yields this year given sticky inflation and high debt. When bond yields rise, their price falls.

Britain's 10-year gilt yield has surged 100 basis points this year , underperforming U.S. and German peers.

It was last trading 2 bps higher on the day at 4.583%, in line with U.S. Treasuries. Rate-sensitive two-year bond yields fell more sharply and were last 1 bp lower.

"The UK needs some stimulus and the way the bank votes split today suggested that we could see maybe three cuts next year instead of two," said Neil Birrell, CIO at Premier Miton Investors.

"I'm genuinely struggling to see where the growth is coming from."

Traders price in roughly 55 basis points worth of British rate cuts next year, compared with around 45 bps just before the decision.

"We're overall positive on fixed income as yields at the moment are quite attractive," said Ielpo, adding this included gilts.

The BoE contrasted with the Fed, which on Wednesday cut rates but said it envisaged just two reductions next year instead of the previous four, sending the dollar surging and the pound down more than 1%.

Britain's FTSE 100 was last down 1.1%, trimming earlier falls. Mid-sized companies on the FSTE 250 index also perked up somewhat, with the gauge last down 1%.

Birrel said he maintained a positive bias on British stocks.

(Reporting by Harry Robertson and Naomi Rovnick, Writing by Dhara Ranasinghe; Editing by Alex Richardson)