Gilts start 2015 rallying, but ECB and supply glut signal reversal

LONDON, Jan 2 (Reuters) - British government bond prices rose moderately on Friday, although possible stimulus from the European Central Bank this month and a heavy auction schedule looks likely to weigh on relative performance and prices over the next few weeks.

Ten-year gilts underperformed against comparable German Bunds euro zone debt as expectations mounted that the ECB is set to fight the threat of deflation with stimulus measures in the next few months.

A weaker-than-expected survey of U.S. manufacturers, which followed a similarly disappointing report from Britain helped gilts recoup earlier losses and move into positive territory, leaving yields more than 2 basis points down on the day at 1.73 percent as of 1600 GMT.

Vatsala Datta, fixed income strategist at RBC (Other OTC: RBCI - news) , said the gilt market was now fixated on whether or not the ECB would announce a quantitative easing programme (QE) to purchase euro zone government bonds this month at its Jan. 22 meeting.

"If we do see the ECB embarking on sovereign QE, that could be the trigger for higher (gilt) yields as the market shifts expectations for inflationary pressure and recovery in the euro area."

Looking further ahead, Datta said the Bank of England's February economic outlook and national elections in May could also be big drivers for the gilt market.

"The key thing to look out for is any sign of wage pressure. In an environment of falling oil prices, it's going to be domestic inflationary pressure that would change the rhetoric of (Monetary Policy Committee) members," said Datta.

Just two of the MPC (KOSDAQ: 050540.KQ - news) 's nine rate-setters have voted for higher interest rates since last August, and markets currently price in a first BoE (Shenzhen: 200725.SZ - news) rate hike only around the end of 2015.

The yield spread between 10-year gilts and the equivalent German Bund whipsawed on Friday and was last up around 2 basis points on the day at 122.5 basis points, having earlier touched a day's high of 126.2 basis points.

Datta said this month's heavy schedule of long-dated gilt auctions, plus a syndication, could also force yields higher.

Britain's Debt Management Office (DMO) will sell 2.75 billion pounds ($4.23 billion) of the 10-year benchmark gilt on Tuesday, followed by 950 million pounds of the 0.125 percent 2044 index-linked gilt on Wednesday.

A syndication of the 0.125 percent 2058 linker is also due to take place late this month, and strategists think it could draw nearly 5 billion pounds.

"Although the DMO is only scheduled to raise 3.6 billion pounds in cash in this final syndication, we think the remaining 1 billion pounds planned to be raised via mini-tenders will be transferred to this syndication, given the expected demand," Morgan Stanley (Xetra: 885836 - news) strategist Anthony O'Brien wrote in a note to clients.

March long gilt future 119.77 (+0.24)

June 2015 short sterling 99.37 (+0.01)

Dec (Shanghai: 600875.SS - news) 2015 short sterling 99.19 (+0.01)

10-year yield 1.73 pct (-2.5 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

($1 = 0.6496 pounds) (Reporting by Andy Bruce)