By Kim-Mai Cutler Oct. 24 (Bloomberg) -- The pound fell below $1.60 for the first time in five years before a report that may show the U.K. economy contracted in the third quarter, bringing the nation to the brink of a recession. The British currency headed for its biggest weekly drop against the dollar in 16 years. Gross domestic product contracted 0.2 percent in the three months through September, according to the median forecast from 35 economists surveyed by Bloomberg. Economic output was flat in the previous period. Bank of England Governor Mervyn King said this week he expects a ``sharp and prolonged slowdown'' in demand. ``We expect the currency to continue underperforming the greenback,'' wrote Geoffrey Yu, a London-based currency strategist for UBS AG. ``King warned that Britain's economy is probably entering its first recession in 16 years and before the government stepped in, the U.K. banking system was closer to collapse than at any stage since World War I.'' The U.K. currency fell to $1.5928, the lowest level since September 2003, and traded at $1.5950 as of 7:37 a.m. in London, from $1.6230 yesterday. It brought this week's drop to 7.7 percent. Against the euro, the pound weakened to 79.95 pence, dropping for a fifth day, from 79.69 pence. A collapse in credit markets and the worst housing slump in a generation have buffeted the British economy, Europe's second- biggest. The U.K. is already in a recession and the economy will contract for the next three quarters, Ernst & Young's ITEM Club, which uses the same forecasting model as the Treasury, said in a report on Oct. 20. House Price Slump House prices will continue to fall and the pound may depreciate further, King said in a speech to executives in Leeds, England on Oct. 21. ``The combination of a squeeze on real take-home pay and a decline in the availability of credit poses the risk of a sharp and prolonged slowdown in domestic demand,'' King said. The Monetary Policy Committee ``will act promptly to ensure that inflation remains on track to meet our target.'' Prime Minister Gordon Brown predicted the next day that the U.K. will slip into a recession for the first time since he took charge of Britain's finances in 1997. The remarks were Brown's first admission that the country's longest unbroken streak of economic growth in more than a century is over. Traders are starting to speculate the Bank of England will lower its benchmark interest rate by as much as three-quarters of a percentage point by year-end to revive the economy. The odds of a cut of that magnitude were 5 percent yesterday, a Credit Suisse Group AG index of derivatives showed. Government bonds were mixed yesterday. The yield on the two- year gilt rose 6 basis points to 3.25 percent. The 4.75 percent note maturing June 2010 fell 0.10, or 1 pound per 1,000-pound ($1,595) face amount, to 102.35. The yield on the 10-year security dropped 1 basis point to 4.47 percent. Bond yields move inversely to prices. The Office for National Statistics will release its report on GDP growth at 9:30 a.m. today in London. To contact the reporter on this story: Kim-Mai Cutler in London at kcutler@bloomberg.net

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