By David Milliken and Fiona Shaikh
LONDON (Reuters) - Britain's manufacturing sector shrank at its fastest pace in three years in May as orders nosedived, dealing a body-blow to hopes of an early end to recession and raising the chances that the Bank of England will inject more stimulus to boost growth.
The latest Markit/CIPS manufacturing PMI - a closely watched index of purchasing managers' views of the sector - will also add to calls for Britain's Conservative-led coalition to find ways to boost growth as it presses ahead with austerity plans.
"This is a collapse, this is a huge decline. We're still a little bit above the lows we hit in the depths of the 2009 recession, but we're heading that way sharply," said Ross Walker, an economist at RBS.
The headline activity index plunged to 45.9 in May from a downwardly revised 50.2 in April, its lowest reading since May 2009 and the second-steepest fall in the survey's 20-year history. Analysts had expected a more modest dip below the 50-point mark that separates contraction from expansion, to 49.8.
Ten-year gilt yields fell to a record low below 1.5 percent after the data, on bets that more BoE quantitative easing was in the offing, and sterling sank to a 4-1/2 month low versus the U.S. dollar, as traders worried the euro zone debt crisis was increasingly hurting Britain.
Markit said the sharp decline in activity reflected the first contraction in manufacturing output in six months and the steepest decline in new orders since March 2009.
"Perhaps of greatest concern is that this month's drop is not simply linked to the ongoing crisis of the euro zone, but to increasing weakness of the UK domestic market," said Markit economist Rob Dobson.
In a further sign of the darkening economic outlook, earlier on Friday the British Chambers of Commerce cut its 2012 GDP growth forecast to 0.1 percent from 0.6 percent - well below what the government and BoE have penciled in.
PMI surveys this year had offered a much rosier picture of Britain's economy than official data and were also stronger than their euro zone equivalents.
They were a major reason why the BoE had discounted official data showing Britain's economy entered recession at the end of last year. This view, along with sticky inflation, helps explain why the BoE halted its QE asset purchase program last month.
But economists say that Friday's data now makes next week's BoE policy decision more finely balanced - especially if the PMI survey for Britain's large services sector, due for release on Wednesday, shows a similar decline.
"We doubt that this on its own will bring about a change of heart from the MPC next week but it is not totally impossible that the committee acts," said Investec economist Philip Shaw.
Before the data, economists polled by Reuters had given a 25 percent chance of an expansion to the BoE's 325 billion pound QE program next week, and around a 50 percent chance of future asset purchases, primarily of gilts, with newly created money.
Some economists raised the possibility that the sharp fall in the manufacturing PMI could be partly due to early factory closures ahead of public holidays to mark Queen Elizabeth's Diamond Jubilee next week, though most agreed the figures still pointed to a marked slowdown.
Markit's Dobson said the survey indicated manufacturing - which makes up about 10 percent of British economic output - could fall by 1 percent between April and June, raising the risk of Britain's recession continuing for a third quarter.
An escalation of the euro zone debt crisis in recent weeks, with instability in Spain's banking system and a Greek election on June 17 raising the risk of a euro zone break-up, may also cause some BoE policymakers to rethink their stance.
BoE deputy governor Charles Bean said in an interview on Thursday that the Bank had scope to restart its asset purchase program if things took a turn for the worse in Europe.
Friday's survey, which also showed firms laying off staff for the first time in six months, and a marked slowdown in firms' raw materials costs and factory gate prices, could also help to tip the balance in favor of more QE.
It will also push the coalition government to come up with measures to support growth at a time when its five-year austerity program is sapping demand and boosting support for the opposition Labour Party.
"Politically, it's going to put more pressure on the government to come up with a plan B," said Tom Vosa, economist at National Australia Bank.
(Additional reporting by David Milliken and Fiona Shaikh; Editing by Catherine Evans)