Gilt yields drop to two-month low on UK recession fears

* Factory and mortgage data highlight UK economic weakness * Ten-year gilt yields hit lowest since Dec. 31 * Markets see 50 pct chance BoE will boost QE next week LONDON, March 1 (Reuters) - British government bonds rallied on Friday, pushing yields to a two-month low, after new signs of economic weakness raised speculation that the Bank of England will opt next week to pump more cash into the economy. Despite the fact that ratings agency Moody's stripped Britain of its triple-A credit rating late last Friday, gilt yields have dropped by almost 25 basis points this week - the biggest one-week fall since November 2011. Benchmark 10-year gilt yields tumbled 10 basis points on Friday alone to hit a low of 1.868 percent - almost twice the fall in Bund yields - as investors priced in a greater chance that Britain's central bank will announce a new wave of gilt buying on Thursday. Solid U.S. economic data later in the day, which showed vigour in the manufacturing sector and improved consumer sentiment, did nothing to brake the upward move in gilt prices. A Reuters poll taken Feb. 26-28 gave a median 40 percent probability of another round of quantitative easing (QE) being announced next week. Analysts said Friday's data, which showed that manufacturing shrank unexpectedly last month and mortgage approvals for home purchases dropped in January, had raised that probability. "It's a very disappointing set of data and makes next week's Bank of England policy decision very finely balanced," said David Tinsley at BNP Paribas. Minutes to last month's meeting showed three of the bank's nine members were already convinced of the need for more quantitative easing. If UK services data, due on Tuesday, is weak, more may fall into that camp. "If we see similar weakness in the UK services PMI next week, the BoE may feel they have no option but to ease further," said Nick Stamenkovic at Ria Capital Markets. "The decision is already on a knife-edge. I'd say it's 50:50" The June gilt future settled 79 ticks higher at 117.48, outperforming its German equivalent by more than 25 ticks. In the cash market, yields fell across the board with the biggest moves seen in the middle of the curve where most of the BoE's gilt purchases have been concentrated. The yield differential between 10-year gilts and Bunds tightened by 6 basis points to 46 basis points as gilts outperformed, having briefly sunk to its lowest level since Feb. 6 at 45.5 basis points. Just a couple of weeks ago, most economists had expected that Britain's central bank would sit on its hands this year or at least not change policy before Bank of Canada Governor Mark Carney arrives in July to take over. But recent signs the economy is teetering again have changed that, and comments from BoE policymakers suggest a new willingness not just to consider more quantitative easing but to look at alternative ways of boosting growth. Earlier this week, BoE Deputy Governor Paul Tucker raised the possibility the bank could charge banks to hold their money, a move which would make it more attractive for them to lend it to companies instead. "The interesting thing for the market is whether the BoE just looks at QE or whether it looks at additional easing steps," said Stamenkovic. "The bottom line is that the UK economy is in a parlous state and may well need additional help." * March gilt future 117.48 (+0.79) * June short sterling 99.565 (+0.025) * Sept short sterling 99.595 (+0.025) * 10-year yield 1.87 percent (-10 bps) --------------------- KEY MARKET DATA--------------------------- Long Gilt futures Gilt benchmark chain Short Stg futures Cash market quotes Deposit rates Sterling cross rates UK debt speedguide --------------------KEY MARKET REPORTS-------------------------- Gilts Sterling Euro Debt Dollar U.S. Treasuries Debt reports -------------------- GILT STRIPS DATA -------------------------- Gilt strips data All gilt strips Gilt strips IO Gilt strips PO A list of all the strippable British gilts