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UK economic activity fell unexpectedly for the first time since January as higher borrowing costs hit demand, according to a survey that prompted markets to reassess their interest rate expectations and buy gilts.

British government bonds recorded their biggest fall in yields for months after August’s flash UK composite purchasing managers’ index prompted investors to scale back forecasts of peak interest rates to below 6 per cent. Sterling fell 0.16 per cent against the dollar to $1.2714 after an initial sell-off was pared back.

The PMI figures, a measure of the health of the economy, were 47.9 in August, down from 50.8 in July and below the neutral 50 threshold for the first time since the start of the year.

A reading below 50 indicates a majority of businesses reporting a contraction and August’s figure was well below the 50.3 forecast by economists in a Reuters poll.

The figures will be scrutinised by Bank of England policymakers as they decide next month whether to lift interest rates for the 15th consecutive time since December 2021. The central bank’s benchmark rate now stands at 5.25 per cent, a 15-year high.

Paul Dales, economist at the consultancy Capital Economics, said the data would encourage the BoE “that higher rates are working” and that GDP would soon contract, triggering “a mild recession”.

In an indication of markets’ belief that interest rates will not now rise as much as previously thought, UK government bonds recorded their biggest daily price gains since the collapse of Silicon Valley Bank in March. As investors bought bonds, 10-year gilt yields, which move inversely to prices, fell 0.18 percentage points to 4.46 per cent.

The swap market is now pricing in a peak of less than 6 per cent in the BoE’s benchmark interest rate early next year, at 5.8 per cent.

Dales added that “dual signs of weaker activity and easing price pressures” in the PMI figures strengthened his view that interest rates would “peak around 5.5 per cent rather than the 6 per cent priced into the markets before this release”.

Chris Williamson, chief business economist at S&P Global Market Intelligence, which publishes the PMI survey with the Chartered Institute of Procurement & Supply, said a renewed economic contraction “already looks inevitable, as an increasingly severe manufacturing downturn is accompanied by a further faltering of the service sector’s spring revival”.

He calculated that the survey was indicative of gross domestic product declining by 0.2 per cent over the third quarter so far.

Jordan Rochester, a foreign exchange strategist at Nomura, now expects the pound to weaken further to $1.22 by October. “We were at these PMI levels last October when things were pretty darn bad with energy prices — these are numbers that will make the Bank of England think twice when delivering more interest rate rises,” he said.

Martin Beck, chief economic adviser to the EY Item Club, a consultancy, said the data reinforced his impression “that a rate rise next month, if it happens, will likely be the last in the current cycle”.

But he cautioned the findings “may not be enough to deter the Bank of England from raising interest rates [in September], given recent developments in pay and services inflation”.

The figures follow more resilient economic data, including better than expected statistics for public borrowing and growth in the second quarter.

Companies responding to the PMI survey reported a fall in orders for goods and services as the cost of living crisis, higher borrowing costs, export losses and concerns about the economic outlook hit demand.

Activity in the services sector contracted for the first time since January, with the lowest output reading in 31 months. The downturn in the manufacturing sector accelerated, marking the sixth consecutive month of falling output.

The survey, based on interviews carried out between August 10 and August 21, reported that input costs rose at the slowest pace for two-and-a-half years, while average prices charged by private sector companies increased at the lowest rate since February 2021.

Weaker demand will be welcomed by BoE rate-setters after official data showed regular wages rising at the fastest pace on record in the three months to June, which suggested persistently high underlying price pressure.

Jobs growth eased between July and August, with employment expanding at the slowest pace since March, but survey respondents pointed to continuing difficulties in recruiting and retaining suitably skilled staff.

Faltering activity in the UK was mirrored in the eurozone, where the composite PMI index fell to a 33-month low of 47.