Markets are doubling down on bets for a UK recession after the Bank of England delivered an outsized rate hike on Thursday, steering investors away from sterling and back into battered government bonds.

The BoE hiked by a larger than expected half a percentage point to 5%, following an inflation scare the day before. Investors have ramped up their bets that rates could peak close to 6% early next year.

This month, the prospect of further rate increases had already supported sterling and pummelled shorter-dated UK bonds, with yields on the securities reaching 15-year highs.

But instead of the BoE boosting sterling, the currency has dropped 0.4% against the dollar this week, and a market-based gauge of economic health has deteriorated by the most in June since the mid-1990s.

WANING CREDIBILITY

A mini-budget last year that sparked financial market chaos, three changes of prime minister since 2019, and a general election due next year all make the UK risky for global investors.

The FTSE 250 share index, which is more reflective of the UK economy than the internationally focused FTSE 100, has underperformed global stock indices, slipping 1.9% year-to-date.

The BoE's bumpy economic forecasting may also be causing investors to charge Britain more to borrow.

It has consistently predicted inflation will fall faster than it has. The Bank forecast headline inflation would slow to 8.4% in April. Instead, the annual rate was 8.7% and it stayed there in May.

Governor Andrew Bailey has said the central bank has "very big lessons to learn" about how to operate during periods of big shocks.

Huw Davies, fixed income manager at Jupiter Asset Management, said: "The Bank of England, but the UK also, has lost some credibility on the international markets."

TRADING A RECESSION

The consensus among economists polled by Reuters is for the UK economy to grow 0.2% this year, although not all investors believe it.

"Inflation is horrific," said Juan Valenzuela, fixed income portfolio manager at Artemis, who is buying two- and five-year gilts.

"Inevitably, the BoE will have to respond," he said, with a short-term series of rate hikes that "cause enough economic damage that the BoE will (then) have to cut (rates) quite aggressively."

Gilts tend to perform well when interest rates fall, which cause bond yields to drop. Two-year gilt yields rose on Thursday, to hold above 5%.

PIMCO, the world's largest owner of government bonds, has said it sees value in UK gilts, as has Blackrock Investment Institute, the research arm of the world's largest asset manager.

Daniel Lockyer, senior fund manager at asset manager Hawksmoor, echoed this view, saying he was adding index-linked gilts to his funds that would "benefit if rates start coming down."

Another signal of impending recession: the gilt yield curve is the most inverted since 2000, meaning bondholders want more compensation for lending for two years than for ten, upending usual lending practices. This gap has yawned by 53 bps in June, the biggest monthly increase since June 1994.

STERLING: WHAT NEXT?

Sterling hit a 14-month high of $1.285 last week against the dollar and is also near a 10-month high versus the euro.

Goldman Sachs, UBS, Bank of America and Barclays said recently they see sterling's strong run continuing.

"The outlook for the (UK) consumer is way stronger than it was," said Michael Cahill, G10 FX strategist at Goldman Sachs, citing recent falls in natural gas prices.

Recession fears are clouding this bullish view, however.

"There's an argument that if higher rates begin to pressure the UK's economic growth, the pound will weaken," said Ian Tew, head of G10 spot trading at Barclays.

STAYING HUMBLE

Not everyone takes the view that recession is inevitable.

The fact the UK economy is still growing is a reason to be "slightly short of gilts, but long of the currency," Jupiter's Davies said.

Investors in UK assets have plenty of unpredictability ahead. As next year's election approaches, investors remain mindful of how UK markets were crushed last autumn by former prime minister Liz Truss' largely unfunded tax-cutting pledges.

"There is a certain randomness to the UK economy," Artemis' Valenzuela said.

"One thing we know for sure is that it's important to stay humble."

(Reporting by Naomi Rovnick and Harry Robertson, graphics by Harry Robertson; editing by Amanda Cooper and Hugh Lawson)