By Amanda Cooper
LONDON (Reuters) - The pound sagged and UK government bond prices rose on Friday, after a shock drop in British consumer spending in December raised the risk of recession, putting a stop to the currency's recent gains.
The Office for National Statistics said people doing their Christmas shopping earlier than usual - especially for food - contributed to retail sales volumes shrinking 3.2% between December and November.
Sterling eased, down 0.16% on the day against the dollar $1.2685 and fell 0.18% against the euro, to 85.76.
That was a reversal of recent moves. The pound on Thursday hit its strongest in a month on the euro, and while the dollar has strengthened across the board this year, sterling has fallen the least among G10 currencies.
Part of the strength of the pound over the past year has come from the belief among investors that the BoE is unlikely to cut rates as quickly as the European Central Bank or the Federal Reserve.
Friday's data on retail sales, which fell by the most in three years, did not shake that view - not least because of figures earlier in the week that showed an unexpected rise in inflation in December - but they did complicate the rate outlook.
"The release has thrown cold water on the sterling rally after the CPI-induced gilt sell-off this week," ING strategist Francesco Pesole said, adding that service-sector inflation was a higher priority for the BoE.
"This means that a further repricing lower in BoE rate expectations would require markets to make a conviction call that the December CPI surprise was just a blip," he said.
Markets currently indicate roughly a 50% chance the BoE cuts rates in May.
Two-year gilt yields, which tend to be more sensitive to changes in expectations for interest rates, fell 6 basis points on the day to 4.247%, outperforming both two-year German yields and U.S. Treasury yields.
Where gilts and the pound go next depends on how investors think the Bank of England will try to square the circle of a slowing economy and stubborn inflation.
"Retail sales are desperately weak, but services do seem to be showing some signs that growth is still happening and yes, it does put the Bank of England in a difficult situation," said City Index strategist Fiona Cincotta.
"Broadly speaking, inflation is at the level that it is and they're not going to take the risk of taking their foot off the gas too early," said.
Economists pinned the decline on consumers front-loading their holiday shopping in November, when retail sales rose by a surprisingly large 1.3%, to spread the cost.
A number of major retailers this week have reported robust Christmas sales figures, predominantly for food, with supermarkets Sainsbury's and Tesco (LON:TSCO) upbeat.
The problem lies more with spending beyond the essentials, as evidenced by sportswear retailer JD Sports Fashion issuing a profit warning this week.