RPT-UPDATE 1-Short UK bond yields rocket as investors ramp up rate hike bets

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* Natural gas price spikes raise fears of inflation

* German-UK bond yield spreads widest since 2016

LONDON, Oct 11 (Reuters) – British government bond yields soared on Monday to their highest level in two-and-a-half years as investors became increasingly convinced that the Bank of England will raise interest rates before the end of the year.

The lurch higher came in light of comments from BoE Governor Andrew Bailey and fellow rate-setter Michael Saunders, who both stressed the need to prevent expectations of rising inflation from becoming embedded.

Investors have singled out gilts for heavy selling among major government bond markets, reflecting not just the prospect of BoE rate hikes but a judgement that Britain appears to be especially prone to entrenched inflation pressure right now.

There was disarray in Britain in recent weeks as a deficit of truckers left fuel pumps dry across the land and a spike in wholesale natural gas prices tipped several energy companies into bankruptcy.

Underlining the tumult in British markets, on Friday Goldman Sachs said it expected the 10-year yield to reach 1.2% by the end of the year.

As it happened, the 10-year yield breached 1.2% in early trade on Monday, up from 1.16% last week’s close and marking its highest since May 2019.

Short-dated gilt yields however saw the biggest increases on Monday, with the 2-year yield rising above 0.6% for the first time since January 2020 – up 7 bps on the day.

Kenneth Broux, an FX strategist at Societe Generale in London, said the comments from Bailey and Saunders only served to boost a growing impression among investors that the BoE will raise interest rates by the end of the year.

“They are beating the drum since the last meeting so you’ve got to take it seriously that they might go as soon as November. Labour market data tomorrow and then GDP on Wednesday will add suspense for sure,” Broux added.

The BoE now looks likely to raise interest rates far in advance of the U.S. Federal Reserve and the European Central Bank. That marks a remarkable shift in market thinking, which only last month pointed to rate hikes in the second half of 2022.

Reflecting this, the gap between yields for the 10-year gilt and the equivalent, lower-yielding, German Bund rose to 132 bps on Monday, the biggest spread since 2016.

Interest rate futures traded on the CME showed November contracts were pricing in as much as a 20% probability of a BoE rate hike next month compared to 12% last week while December futures were pricing in a 45% probability of a rate increase by then.

A separate estimate from Refinitiv based on interest rate futures suggested a 15 bps rate hike by December is now fully priced in.

Some investors have already been burnt by the rush to price in BoE rate hikes.

On Monday RBC said it pulled out of its recommendation to go long on March 2022 SONIA futures, which had been made on the basis that it thought the market had priced in BoE rate hikes too aggressively.

“The trade has continued to move against us, and we have been stopped out,” the bank said in a note to clients.

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