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UPDATE 3-Sterling sinks to new low as 'mini budget' shatters investor faith in UK markets

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Pound briefly touched a record low against dollar

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Gilts continue to collapse

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Government refuses to comment on market reaction

(Adds government response)

By Amanda Cooper and David Milliken

LONDON, Sept 26 (Reuters) - The pound plunged to a record low against the dollar early on Monday and British bond prices collapsed as fears mounted over the new government's fiscal plan, unleashing calls for an emergency Bank of England rate hike to restore confidence.

New finance minister Kwasi Kwarteng sent sterling and government bonds into freefall on Friday with a so-called mini-budget that was designed to grow the economy by funding tax cuts with huge increases in government borrowing.

On Sunday, in a BBC interview, he listed the tax cuts he had made and added: "There's more to come".

As trading resumed in Asian markets on Monday the pound plunged by as much as 5% against the dollar to touch $1.0327, its weakest on record, before it pared most of the day's losses in European trading.

In the gilt market, the pressure was even more intense, with five-year bond prices on track for their second-biggest daily fall since at least 1991, behind only Friday's historic slump.

The two-year yield reached its highest since September 2008 at 4.573%, up a full percentage point in the last two trading days, as Prime Minister Liz Truss's government lost credibility with investors.

Mohamed El-Erian, chief economic adviser at Allianz, said the central bank would have no choice but to raise interest rates if Truss and Kwarteng did not back down.

"And not by a little, by 100 basis points, by one full percentage point to try and stabilise the situation," he told BBC Radio.

Interest rate swaps price in a high chance of a chunky Bank of England rate rise within the next week, well before its next scheduled rate announcement on Nov. 3, and see the BoE's main rate reaching 4% by the end of the year, up from 2.25%.

TREASURY ORTHODOXY

Truss, Britain's former foreign secretary, was elected as prime minister earlier this month by a vote of the Conservative Party's 170,000 members - not the broader electorate - following an internal rebellion that drove Boris Johnson out of power.

She largely beat her rivals to the top job by vowing to reignite economic growth through tax cuts and deregulation to bring an end to the largely stagnant real wage growth that has marked her party's 12 years in government.

Her pledge to end so-called "Treasury orthodoxy" and go for growth marks a step change in British financial policy, harking back to the Thatcherite and Reaganomics doctrines of the 1980s.

Truss's policy breaks too with more recent efforts by previous chancellors such as George Osborne to balance the books.

Kwarteng, an economic historian who specialised on the end of the 17th century when the value of sterling had plummeted, has declined to comment on the violent market reaction. A person close to the finance minister said he was unmoved by events.

"Markets go up and down," one veteran Conservative Party source said, declining to be named. "We did something structural, short term, that will have seismic and positive long term benefits."

However, the scale of the market turbulence has started to rattle some in the party, with one lawmaker saying those who were less ideologically close to Truss were "very worried", as constituents emailed them to express alarm. The lawmaker asked not to be named.

Rachel Reeves, a former economist at the Bank of England (BoE) who is now the financial policy chief for the opposition Labour Party, said she was "incredibly worried" by the reaction.

Investors and analysts were more direct.

"The British have decided that going back to the 1980s on steroids is the best way to go, and clearly the market is just saying: 'That's not going to work'," Michael Every, Rabobank strategist, said.

"The market is now treating the UK as if it's an emerging market. And they're not wrong in terms of the policy response and the naivety of thinking that boosting demand rather than supply is how you deal with a supply-side shock."

The pound had rebounded to $1.0850 as of 1334 GMT, leaving it roughly flat on the day, but there was no recovery in gilts.

A spokesman for Truss declined to comment.

DOOMSDAY CULT

Paul Donovan at UBS said investors seemed "inclined to regard the UK Conservative Party as a doomsday cult".

Some economists warned that an emergency rate hike would sow yet more panic. "I think that would add to the sense of nervousness and panic rather than calming it down," Andrew Sentance, a former BoE policymaker, told Sky News.

Further highlighting the extent to which investors have punished UK assets, the difference in the 10-year borrowing costs for the British and German governments exploded to its widest since 1992, when Britain crashed out of the European Exchange Rate Mechanism.

British 10-year government bond prices are now on track for their biggest slump of any calendar month since at least 1957, according to a Reuters analysis of Refinitiv and BoE data.

In response to that statistic, Paul Johnson, the head of the Institute for Fiscal Studies, attacked the government's decision to ignore the usual rules. "This will cost billions," he said on Twitter. "Economic and fiscal constraints are real. It's not just 'Treasury orthodoxy'".

(Writing by Kate Holton and Amanda Cooper; additional reporting by Elizabeth Piper, Kylie MacLellan, Andy Bruce and Harry Robertson; Editing by Hugh Lawson and Mark Potter)