The pound weakened against the dollar and euro while two-year gilts surged after a report showed U.K. manufacturing slowed, boosting bets that the Bank of England will keep its key interest rate at a record low this week. Sterling slumped versus all of its 16 major peers, losing the most against the yen. An index of U.K. manufacturing by Markit Economics and the Chartered Institute of Purchasing and Supply unexpectedly declined to 54.6 from a revised 56.7 in March. Central bank Governor Mervyn King said yesterday that government indebtedness globally would worsen if interest rates were to rise. Two-year gilt yields fell the most in two weeks. “The chance of a rate hike in May has been priced out of the market, and that’s been corroborated by the manufacturing data,” said Stephen Gallo, head of market analysis at Schneider Foreign Exchange in London. “The comments by King have also gotten sterling bulls pretty worried. The market today is pushing back its rate-hike expectations, so that’s why the two- year note yield is dropping.” The pound fell 1 percent to $1.6494 as of 12:13 p.m. in London. Britain’s currency weakened 0.7 percent to 89.67 pence per euro, and slumped 1.4 percent to 133.34 yen. U.K. two-year notes rose for a second day, reducing yields on the security due March 2013 by 14 basis points to 1.03 percent, the least since Dec. 6. The 10-year gilt yield declined one basis point to 3.44 percent. The Bank of England is expected to keep its benchmark interest rate at a record low 0.5 percent when it announces its next decision on May 5, according to the median estimate of 43 analysts surveyed by Bloomberg. Pound ‘Suffering’ “The market is mainly reflecting that the Bank of England will probably keep rates on hold,” said Elizabeth Gregory, a Geneva-based market strategist at Swissquote Bank SA. “It’s the main reason the pound is suffering.” The pound slumped to the lowest since records began in 1975 against a basket of nine of its most-traded peers, according to Bloomberg Correlation-Weighted Currency Indexes. The index’s pound value dropped as low as 60.70. U.K. policy makers face increasing pressure to raise borrowing costs to curb inflation, which has soared to more than twice the central bank’s 2 percent target. Even so, inflation unexpectedly slowed for the first time in eight months in March, to 4 percent after reaching 4.4 percent in February. Economists predicted the manufacturing gauge would slip to 57 in April, according to the median of 19 estimates in a Bloomberg survey. Last month’s reading, while the least since September, remained above the 50 level that indicates expansion. High levels of debt pose “massive” challenges for the economy that “will last for many years,”King said yesterday at a committee of the European Parliament in Brussels. “The economic consequences of high-level indebtedness now would become more severe if rates were to rise,” said King. U.K. retailers’ outlook for sales deteriorated to the weakest in a year and conditions may remain “tough,” the Confederation of British Industry said. While a gauge of sales rose to 21 from 15 in March, a measure of shops’ outlook for the current month dropped to minus 1 from 18 in April, the London- based business lobby said in a report today. To contact the reporter on this story: Garth Theunissen in London gtheunissen@bloomberg.net To contact the editor responsible for this story: Daniel Tilles at dtilles@bloomberg.net

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