LONDON (Reuters) - Sterling surged to its highest in a week against the euro on Thursday after as many as three members of the Bank of England's policy committee surprised financial markets by voting for a rise in interest rates.
Trading below $1.27 before the BoE's decision, the pound leapt by a full cent to $1.2795 after it emerged that Ian McCafferty and Michael Saunders had voted with existing policy hawk Kristin Forbes for higher borrowing costs.
At a time when the BoE has blamed a rise in inflation past its 2 percent target on a weak pound, traders read the split vote as warning that officials could seek to defend the currency with rhetoric or action even as the economy overall slows.
It was also just the latest surprise in a week which has seen the pound slump after British Prime Minister Theresa May lost her parliamentary majority in an early election.
"There is a clear emphasis on the risk of a sustained inflation overshoot and the Bank of England probably does not want to be seen as being dismissive of such concerns," UBS Wealth Management's Head of the UK Investment Office, Geoffrey Yu, said.
Short sterling contracts for December of this year moved 6 basis points, raising the likelihood attached to a rise in the bank's main interest rates before the end of 2017 to about 30 percent. <0#FSS:>
Two-year gilt yields hit their highest since May 10 as prices tumbled, and the euro zone's benchmark German 10-year bond yield also hit a day's high of 0.265 percent.
But the implications for growth and company profits in an economy already slowing sharply were evident in a slump for both Britain's main FTSE 100 index and more domestically focused mid-caps.
The internationally focussed FTSE 100, which has tended to rise as the pound falls in the past year, hit a session low of 1.1 percent. Mid-caps saw their sharpest one-day fall in nearly a year, down 1.9 percent.
Upsetting London's stock market, already facing a slowing domestic economy, Brexit talks due to start next week and months of political uncertainty around a new minority government, is one risk the BoE would be taking by raising rates.
Dominated by companies whose revenues come from abroad, the blue-chip index has benefited from the pound's fall in the past year. Reversing that might hurt.
Equally, for a country with one of the highest household debt burdens in the world, a rate rise would risk triggering falls in housing prices that might leave millions of people with negative equity on long-term mortgages.
"From what they have said in the statement today, it does appear that they seem quite concerned about the weakness of the pound," MUFG currency analyst Lee Hardman said.
"But I'm not sure that the market buys that they are going to follow through, given the recent weakness of the activity data on the economy and the uncertainty generated by the election," he said.
A number of analysts emphasised that the vote may be chiefly a way of the BoE supporting the pound without actually changing policy conditions, noting also that Forbes is due to leave at the end of the month.
"With the economic outlook still challenging, wage growth will likely remain weak which should act as a drag on longer term inflation once the currency impact passes," Oanda analyst Craig Erlam said.
"(That's) assuming we don’t see further dramatic shifts lower in sterling."
Additional reporting by Helen Reid, Ritvik Carvalho and John Geddie; Editing by Hugh Lawson and Louise Ireland