European Bonds Post Third Weekly Gain on Outlook for ECB Rates

By Lukanyo Mnyanda

Aug. 9 (Bloomberg) -- European government notes posted a third weekly gain after central bank President Jean-Claude Trichet said economic growth will weaken, prompting investors to reduce wagers on higher borrowing costs this year.

Two-year notes led the advance, pushing the difference in yield with the German 10-year bund to the widest since May 20, after reports this week added to signs growth in the region is faltering. The European Central Bank held its benchmark rate at 4.25 percent on Aug. 7, after which Trichet said expansion will be ``particularly weak'' in the second and third quarters.

``A lot of people took heart from what Trichet had to say about growth, as there was anxiety that he'd be more hawkish,'' said Marc Ostwald, a fixed-income strategist in London at Monument Securities Ltd. ``There is a sense the ECB is giving some ground.''

The yield on the two-year note dropped as much as 7 basis points to 4.03 percent, and was at 4.07 percent by 4 p.m. in London, heading for its biggest weekly drop since the period through Feb. 8. The price of the 4.75 percent note due June 2010 rose 0.02, or 20 euro cents per 1,000-euro ($1,504) face amount, to 101.16.

The yield on the 10-year bund, Europe's benchmark government security, was at 4.26 percent, leaving it 8 basis points lower in the week.

Government bonds pared gains yesterday as some investors bet there was still a risk the ECB will resume raising interest rates to restrain prices and discourage workers from seeking higher wage increases.

`Market Ahead of Itself'

``In the short term, our suspicion is the market has got ahead of itself,'' Sean Maloney, a debt strategist in London at Nomura International Plc, said.

Trichet told a press conference in Frankfurt there is ``no bias'' or ``pre-commitment'' toward future rate movements, repeating what he said July 3 after the previous rate decision. The ECB has observed ``some materialization of risks that we had identified'' he said.

Factory production in Germany rose by less than economists forecast in June, a government report showed Aug. 7. Separate data a day earlier showed factory orders in Europe's largest economy unexpectedly slipped in the same month.

Yield Difference

The difference in yield, or spread, between 10-year German bonds and U.S. Treasuries has narrowed 19 basis points in the past two weeks, to 33 basis points today. German two-year notes, which are more sensitive to interest-rate changes, yielded 19 basis points less than the 10-year bund, compared with 9 basis points a week ago.

The implied yield on the December Euribor futures contract fell 14 basis points in the past week and was last at 4.93 percent, indicating fewer investors expect the ECB to raise interest rates to fight inflation.

Europe's central bank is struggling to contain inflation which, at 4.1 percent, quickened to more than twice its ceiling in July. The fastest consumer-price growth in 16 years has come as the impact of the economic slowdown sparked by the collapse of the U.S. housing market has spread to Europe.

``The ECB press conference was more dovish than the market was anticipating,'' analysts led by Thorsten Weinelt, global head of research and chief strategist at Unicredit Markets & Investment Banking, a unit of Italy's largest lender, wrote in a client note. ``Expect today's price action to be dominated mainly by a re-assessment of yesterday's strong market movements.''

IMF's View

Europe's economy will grow 1.2 percent next year, with growth in Germany, the largest of the 15 nations that share the currency, slowing to 1 percent from 2 percent this year, according to the International Monetary Fund.

Italy's economy unexpectedly shrank in the second quarter, edging it closer to a fourth recession in a decade as households and businesses struggle to cope with more expensive oil.

The economy, the fourth-largest in Europe, contracted 0.3 percent after expanding 0.5 percent in the first quarter, the Rome-based statistics office Istat said yesterday. Economists expected stagnation, according to the median of 22 forecasts in a Bloomberg News survey. From the same period a year earlier, the economy didn't grow at all.

European government bonds returned investors 2.3 percent this year, while U.S. debt earned 3.1 percent, according to Merrill Lynch & Co.'s EMU Direct Government and U.S. Treasury Masters indexes.

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net