LONDON (Reuters) - Sterling drifted lower on Monday, hurt by the widening differential between U.S. and European bond yields as investors looked nervously toward the Bank of England’s inflation report and an increasingly fraught run in to May national election.
The pound has proved somewhat more stable over the past few weeks after a 4-percent fall in the opening weeks of 2015 due to weakening expectations for rises in interest rates.
Analysts are divided on how the BoE will spin Wednesday’s update on the economy but many are concerned that the combination of a softening economy and political volatility may make for a slightly grim few months ahead.
“GBP needs to be approached tactically with external conditions tightening and political uncertainty raising volatility,” Citi analyst Josh O‘Byrne said in a report.
Along with a handful of others, however, O‘Byrne argued that the market may have become too complacent on the prospect for higher rates over the next year.
“We like being short euros against sterling into the release (of the inflation report),” he said.
Sterling was down 0.2 percent at $1.5216, while against the euro it slipped around 0.3 percent to trade at 74.45 pence per euro.
One factor was a widening gap between U.S. 10-year Treasury yields and their British counterparts.
The U.S. 10-year yield posted its biggest rise in 1-1/2 years on Friday as robust U.S. jobs data stoked expectations that the Federal Reserve will raise interest rates as early as June.
A broad sell-off of riskier assets saw British government bond yields also fall sharply in step with core euro zone government bonds on Monday while U.S Treasury yields were little changed. Five-year gilt yields were last at 1.085 percent, down about 6 basis points on the day.
The BoE is likely to update growth and inflation prospects in the report. Price pressures remain soft and market pricing suggests that may allow the central bank to keep rates at record lows well into 2016.
But the UK economy has consistently outstripped its European peers over the past year and to most still looks a solid bet to maintain that advantage.
“We see the GBP as second only to the US dollar in the G10,” analysts from French bank BNP Paribas said in a weekly note.
“Our economists expect the first rate hike to take place in February 2016, significantly ahead of market expectations. In this context, the GBP should strengthen.”
Editing by Liisa Tuhkanen