U.K. government bonds fell for a second day and the pound surged after the National Institute for Economic and Social Research said the Bank of England will raise interest rates three times this year to curb inflation. The declines pushed the yield on the two-year gilt up to the highest since 2009 while sterling rallied against 13 of its 16 most-traded peers monitored by Bloomberg. The London-based Niesr, whose clients include the U.K. Treasury and the central bank, said the 0.5 percent benchmark rate was likely to rise to 1.25 percent by the end of 2011, compared with an October forecast of 0.75 percent. “The Niesr story is quite significant, it’s an important shift when you see high-profile calls for higher rates,” said Elizabeth Gregory, a Geneva-based market strategist at ACM Advanced Currency Markets, which handles about $150 billion of foreign-exchange trades a month. “The market shows that more and more people are focusing on the inflation side of the story rather than growth.” The yield on the two-year gilt rose eight basis points to 1.38 percent as of 11:57 a.m. in London. It earlier reached 1.41 percent, the highest level since Dec. 30, 2009. The 4.5 percent security due March 2013 fell 0.18, or 1.8 pounds per 1,000-pound ($1,611) face amount, to 106.41. Ten-year yields increased six basis points to 3.71 percent. Short-sterling futures, a gauge of investors’ central bank rate expectations, slumped, pushing the yield on the contract expiring in December up 11 basis points to 1.62 percent. Rate Votes Inflation in the U.K. has exceeded the central bank’s 2 percent limit for more than a year, quickening to an eight-month high of 3.7 percent in December, as fuel and food prices climbed. That prompted Martin Weale, a former Niesr director, to join Andrew Sentance in voting for a rate increase at the Monetary Policy Committee’s Jan. 13 meeting, on concern that inflation may persist above the target. “We’ve had a big bounce in short-term yields because obviously there is a renewed focus on how soon the BOE may raise rates to bring inflation under control,” said Kenneth Broux, senior market economist at Lloyds TSB Corporate Markets in London. “Obviously the article by the Niesr, and stronger manufacturing PMI, does add momentum but we think their call is a bit extreme.” Gilts also fell today as a rebound in stock markets across the world pared demand for fixed-income assets, in favor of equities, said Broux. The U.K.’s FTSE 100 Index rose 1 percent and Europe’s benchmark Stoxx 600 Index rose for the first time in three days, adding 0.9 percent. An index of U.K. manufacturing rose to a record level in January, surging to 62 from a revised 58.7 in December, according to a survey of companies released today by Markit Economics and the Chartered Institute of Purchasing and Supply. The pound advanced as much as 0.8 percent to $1.6142, the strongest level since Nov. 15, before trading 0.6 percent stronger at 1.6110. Britain’s currency was little changed at 85.47 pence per euro. 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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