Key gilt yield falls below 1 per cent for the first time on record

Gilt yields fell to a record low yesterday after a Bank of England survey showed lenders preparing to tighten credit further this year, boosting expectations of a big cut in interest rates next week.

The yield on two-year gilts fell below 1 per cent for the first time as the Bank's quarterly credit conditions survey showed a greater-than-expected reduction in secured lending to households and credit to companies.

The Bank's survey found that concern about the economic outlook and falling asset values had prompted banks to limit lending, risking a downward spiral of falling property prices, increased loan defaults and tighter credit. The rep-ort, which predicted further reining in of lending in the current quarter, came on top of gloomy data from the manufacturing and housing sectors.

Manufacturing shrank for the eighth straight month in December, according to the Chartered Institute of Purchasing and Supply survey. Mortgage approvals in November were at their lowest since the Bank of England started collecting figures in 1999, while a Halifax survey showed a record annual fall in house prices of 16.2 per cent.

The batch of grim data sent the pound down against the dollar and the euro, which hovered just short of record highs above 98p reached earlier in the week.

The Bank has switched from battling inflation to aggressive rate-cutting as it seeks to limit the impact of the first recession since the early 1990s. Rates have fallen 3 percentage points since September and markets are now pricing in an 80 per cent chance that the MPC will cut rates by 75 basis points to 1.25 per cent on Thursday to the lowest since the central bank was founded in 1694.

Howard Archer, chief UK economist at IHS Global Insight, said: "With the recession deepening, credit conditions remaining worryingly tight and inflationary pressures retreating sharply, there is intense pressure on the MPC to bring interest rates down sharply further. We are forecasting a 75 basis point cut from 2 per cent to 1.25 per cent but it is very possible that the MPC could produce a third successive reduction of 100 basis points or more."

The credit survey was conducted after the bankruptcy of Lehman Brothers, which sent funding markets for banks to new levels of turmoil. Lenders in the Bank's survey reported that the changed cost and availability of funds had affected credit availability. The cost of borrowing dollars, sterling and euros in interbank markets fell yesterday, the first chance for markets to ease after banks' year-end, when they hoard liquidity. But the cost of sterling interbank borrowing over expected interest rates widened, while dollar and euro spreads narrowed, suggesting greater fear in the UK market.

The Government has imposed tougher capital requirements on Britain's banks and offered guarantees to banks' credit to try to restore confidence to the financial system. Mervyn King, the Governor of the Bank of England, has highlighted maintaining bank lending as the key to limiting the effects of the recession.

Lenders' plans to squeeze credit further could worsen their relationship with the Government, which has demanded that they maintain lending to households and businesses to support the economy. Banks claim they are continuing to lend and that they are acting in a proper way given the prospects for the economy and the increased risk posed by many borrowers.

The Confederation of British Industry called on the Government to act to restore credit flows across the economy. Richard Lambert, the director general of the CBI, said: "The shortage of trade finance is affecting output across a broad swathe of industry... Inventories are being cut back, and the Bank of England's survey indicates a marked cutback in capital spending programmes over the past three months."