By Anchalee Worrachate
Sept. 13 (Bloomberg) -- The pound rallied against the euro, erasing earlier losses, on speculation the Bank of England's move to ease the lending drought in the credit market may alleviate the effect of the financial crisis on U.K. economic growth.
The central bank today relaxed restrictions on the amount of money financial institutions need to hold with the central bank, encouraging them to lend more to each other. The pound earlier fell to a 14-month low against the euro on speculation the credit market crisis, which has pushed up money market lending rates, will crimp expansion.
``The Bank of England is clearly aiming to reduce the overnight rate,'' said Nick Stamenkovic, strategist at RIA Capital Markets in Edinburgh. ``This might be a small step but it's very well-received by the market and is positive for the pound, at least for now.''
The pound rose to 68.45 pence by 4:40 p.m. in London from 68.51 pence yesterday, after falling to as low as 68.75 pence earlier, its lowest since July last year. The currency was little changed against the dollar at $2.029.
The new BOE's rule will allow commercial banks, which agree to hold a specific amount of money at the central bank at the end of each monthlong maintenance period, to undershoot that target by 37.5 percent and still earn interest at the benchmark rate. That compares with the previous restriction of just 1 percent.
The overnight Libor for pounds fell 3 basis points to 5.87 percent. The three-month rate declined 2 basis points to 6.88 percent, still near its highest since 1998.
The pound fell earlier as a report showing U.K. house prices declined for the first time since 2005 stoked speculation five interest-rate increases by the BOE in the past year are cooling the housing market.
Gilts erased earlier gains after the BOE relaxed its deposit rules and as a five-year bond auction drew lower demand than expected.
The Debt Management Office sold 2.5 billion pounds of a 5.25 percent gilt maturing in 2012. The sale drew bids 1.98 times the amount of securities on offer, compared with an average bid-to- cover ratio of 1.66 times in the previous two auctions.
Gilts sold off as some traders had expected stronger bids on speculation the financial market crisis would boost demand for safest assets, said Richard McGuire, London-based strategist at Royal Bank of Canada, which is one of the DMO's 17 gilt primary dealers.
``The auction was taken down without any difficulty, but it's not quite the impressive result that we in the market had been looking for,'' said McGuire. ``We expected the financial market backdrop to drive demand for short-dated safe-haven assets.''
The two-year gilt yield rose 10 basis points to 5.14 percent after falling to 5.03 percent, its lowest since December. Bond yields move inversely to prices.
The 10-year gilt yield rose 3 basis points to 4.92 percent. The price of the 4 percent bond maturing September 2016 fell 0.19, or 1.9 pounds per 1,000-pound face amount, to 93.35.
Still, gilts outperformed European debt on speculation Britain's interest rates have peaked. The extra yield investors demand for holding 10-year gilts over the equivalent German bund fell to 75 basis points today, the narrowest in a year.
The yield on the December interest-rate futures contract fell 9 basis points to 6.31 percent. The contract settles to the three-month London interbank offered rate for the pound, which has averaged about 15 basis points more than the central bank's key rate for the past decade.
The June 2008 contract rose by 6 basis points, suggesting investors are scaling back their expectations that the central bank may need to cut interest rates next year.