The pound weakened for a second day against the euro amid speculation the Bank of England will cut interest rates at a faster pace than its euro-region counterpart to help drag the economy out of a recession. The British currency also declined versus the dollar earlier after a report showed the U.K. economy shrank more than forecast in the third quarter as service industries fell the most in almost 18 years. Bank of New York Mellon Corp. said Britain’s currency may reach parity with the euro as early as next week. “With market liquidity as thin as it is, I wouldn’t rule out the possibility the pound will reach parity with the euro by year-end,” said Simon Derrick, chief currency strategist in London at Bank of New York. “Talk the Bank of England will cut interest rates again in January, and cut them aggressively, weighed heavily on the pound.” The pound weakened to 94.41 pence per euro by 12:47 p.m. in London, from 93.97 pence yesterday, bringing its decline this quarter to 16 percent. Against the dollar, it was little changed at $1.4823, paring its loss since Sept. 30 to 17 percent. The currency lost 22 percent against the euro this year. U.K. gross domestic product dropped 0.6 percent from the second quarter, the biggest decline since 1990, the Office for National Statistics said today in London. The result was lower than the previous estimate for a decline of 0.5 percent, which economists had expected would be confirmed. Gains ‘Unsustainable’ The pound stayed lower after the British Bankers’ Association said mortgage approvals fell to the lowest in 14 years in November as the economic slump discouraged buyers and financial institutions declined to pass on fully the central bank’s interest-rate cuts. Bank of England Governor Mervyn King refused to rule out that the main U.K. interest rate could reach zero and said on Nov. 25 there would need to be “close coordination” between the government and the central bank in such circumstances because monetary policy then becomes like debt management. Investors should still be wary of betting the pound will fall to parity with the euro, because “such gains will likely prove unsustainable,” said Bank of Tokyo-Mitsubishi Ltd. “It is increasingly likely that the current value of the pound fully discounts negative fundamentals,” Lee Hardman, a London-based currency strategist at Tokyo-Mitsubishi, wrote in a note today. “The pound will likely appreciate modestly on a trade-weighted basis through 2009.” The pound will strengthen to 87 pence per euro by the end of 2009, according to Hardman. Gilts Advance U.K. government bonds rose, with the yield on the two-year gilt declining two basis points to 1.20 percent. The yield on the 10-year gilt declined one basis point to 3.11 percent. The 5 percent security due March 2018 rose 0.13, or 1.3 pounds per 1,000-pound ($1,481) face amount, to 115.01. Investors should buy gilts because the Bank of England is likely to cut its benchmark rate to as low as 0.25 percent, from 2 percent now, in the “early part of next year,” said Andre de Silva, global deputy head of fixed-income strategy in London at HSBC Holdings Plc, Europe’s largest bank. “We favor both the front and the very back ends of the gilt curve,” de Silva said in a Bloomberg Television interview. The yield difference, or spread, between two- and 10-year gilts rose to 192 basis points, from 190 basis points yesterday, the most since Nov. 11. The so-called steepening yield curve suggested investors raised bets that the economic slump will deepen and interest rates will fall. Ten-year gilts headed for their biggest quarterly gain since at least 1989, with yields falling 133 basis points since the end of September. U.K. government bonds returned 12 percent this year, the same as German bonds, according to Merrill Lynch & Co.’s U.K. Gilts and German Federal Governments indexes. U.S. Treasuries handed investors 15 percent. The FTSE 100 index of stocks declined almost 34 percent this year. To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net

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