By Matthew Brown and Anchalee Worrachate Nov. 26 (Bloomberg) -- U.K. government bonds rose, sending the yield on the 10-year gilt to the lowest level in almost two decades, after a government report showed consumer spending dropped the most since 1995 and investment slumped. The benchmark 10-year note advanced for a second day and the pound snapped three days of gains against the dollar after the Office for National Statistics said gross domestic product had its first quarterly decline in 16 years, matching an earlier reading on Oct. 24. U.K. stocks dropped for the first time in three days, with the FTSE 100 Index declining 1.8 percent. “The economy is on its knees, inflation expectations are falling and asset prices are falling,” Laurence Mutkin, head of asset allocation at Morgan Stanley in London, said in a Bloomberg Television interview. That’s “very good news for government bonds.” The yield on the 10-year gilt declined seven basis points to 3.80 percent as of 11:22 a.m. in London, the lowest level since at least 1981. The two-year note yield rose two basis points to 2.18 percent. Yields move inversely to bond prices. A slump in global growth and almost $1 trillion of losses and writedowns at financial institutions fueled demand for the relative safety of government fixed-income this year. The Organization for Economic Cooperation and Development said yesterday that the world’s largest economies need further interest-rate reductions and tax cuts. U.K. industrial production fell by 1.1 percent in the quarter and manufacturing dropped by 1.3 percent, the statistics office said today. Construction declined 0.7 percent. Yield Spread The difference in yield, or spread, between U.K. two- and 10-year notes narrowed seven basis points to 162 basis points today. It widened to a peak of 199 basis points Nov. 17 as investors favored two-year notes on speculation the Bank of England will keep cutting interest rates to buoy the economy, steepening the so-called gilt yield curve. “People are extending out of the curve as the front end prices in pretty low rates from the Bank of England and anticipates the extra supply that we’re going to get,” Jason Simpson, a fixed-income strategist at Royal Bank of Scotland Group Plc in London, said in a telephone interview today. “There’s no reason to expect it not to go lower.” The U.K. will sell a record amount of gilts this year as the looming recession chokes tax revenue. The government will issue 146.4 billion pounds ($225 billion) of debt in the year through March 31, the Debt Management Office said Nov. 24. That’s 83 percent more than the Treasury originally estimated. Pound Falls The pound declined to $1.5357, from $1.5472 yesterday. Against the euro, the U.K. currency traded at 84.49 pence, from 84.43 pence. Bank of England Deputy Governor Charles Bean said yesterday the pound’s slide this year is the “right sort of magnitude.” “There is a distinction between a decline in sterling that is necessary as part of the rebalancing process and one where external investors lose faith in the policy framework the U.K. operates under,” Bean told lawmakers yesterday. “It results in pressure on sterling, an old-fashioned sterling crisis. That I would be much more worried about.” “We wouldn’t chase the pound,” said Geoffrey Yu, a currency strategist in London at UBS AG, the world’s second- largest foreign-exchange trader. “The risk is that it will fall further from here. The Bank of England is cutting interest rates, as well as talking down its currency.” Interest-rate cuts and a deteriorating balance-of-payments outlook will cause the pound to weaken to at least 87 pence per euro in three months, Dresdner Kleinwort said. Policy makers will need to lower the benchmark rate to at least 1.5 percent from the current 3 percent as the economy falters, according to Michael Klawitter, a currency strategist in Frankfurt for the bank. ‘Less Foreign Capital’ “The 87 pence forecast is looking cautious, given the challenges the U.K. is facing,” said Klawitter. “Given the fact that the Bank of England will continue cutting rates and the U.K. is running substantial deficits, it will attract considerably less foreign capital than in the past.” The pound lost 31 percent against the yen, 23 percent versus the dollar and 6.5 percent against the euro since June. Gross domestic product will contract 1.25 percent in 2009, the most since 1991, according to Treasury forecasts, as the worst global financial crisis since the Great Depression takes its toll on the economy. U.K. gilts returned 4.1 percent this month, according to Merrill Lynch & Co.’s U.K. Gilts Index. U.S. and European government bonds handed investors 4.7 percent and 3.5 percent, respectively, Merrill’s U.S. Treasury Master and EMU Direct indexes showed. To contact the reporters on this story: Matthew Brown in London on mbrown42@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net

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