LONDON: Sterling rose towards seven-year highs and gilt yields surged on Thursday after a Bank of England quarterly report said inflation would return to its target of 2 percent in two years' time, keeping alive expectations of a first rate hike in early 2016.
Investors are starting to factor in a chance of the first hike in about 11 months' time, compared with 12 months before the report was released, based on the overnight sterling overnight interbank average rates.
Sterling hit the day's high of $1.5340, up from $1.5226 beforehand, while sterling also firmed to 73.92 pence to the euro from around 74.47, nearly 0.6 percent stronger on the day. Sterling had hit a seven-year high of 73.85 pence on Wednesday.
Long gilt futures fell 70 basis points to 119.85 while the 10-year gilt yield rose to 1.7360 percent, its highest since Jan. 5 and up 6 basis points on the day, as investors priced in greater chances of a rate hike.
BoE Governor Mark Carney said he expected inflation to fall below zero in the coming months due to tumbling oil prices, but stressed that this by itself did not mean the economy had entered deflation. He said the next move by the BoE was likely to be an interest rate increase.
The central bank revised up its growth forecasts and predicted wages would grow faster. Looking beyond the impact of falling oil prices in the short term, the BoE forecast inflation would climb steadily to its 2.0 percent target in two years' time, and a fraction above that in three years.
"Higher growth and inflation forecasts later in the horizon sends a more constructive message that policy risks are in the tighter direction," said Josh O'Byrne, currency strategist at Citi.
"This much is supportive for sterling in the near term and likely to lead to a rally as the market digests the message further."
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