European Notes Decline in Week on Bets ECB Won't Lower Key Rate

By Agnes Lovasz

Aug. 23 (Bloomberg) -- European government notes snapped a four-week advance amid speculation central bank policy makers will delay lowering interest rates to focus on curbing inflation rather than boosting growth.

The drop pushed the yield on two-year German notes, the securities most sensitive to interest-rate changes, to the highest level in two weeks as futures traders scaled back expectations the European Central Bank will cut its benchmark rate. Oil posted its biggest weekly increase in more than two months after rising almost 5 percent on Aug. 21.

``The rise in oil prices weighs on the bond market,'' said Allan von Mehren, a fixed-income strategist in Copenhagen at Danske Bank AS, the biggest lender in Denmark. ``It puts inflation concerns back on the agenda.''

The two-year note yield rose 6 basis points to 4.14 percent by 4 p.m. in London yesterday, leaving it 14 basis points higher in the week. The price of the 4.75 percent note fell 0.25, or 2.5 euros per 1,000-euro ($1,482) face amount, to 101.01.

The yield on the 10-year German bund, Europe's benchmark government security, rose 7 basis points in the week to 4.23 percent. Yields move inversely to bond prices.

The difference in yield, or spread, between two- and 10-year notes was the narrowest in almost three weeks as rate-sensitive short-maturity debt underperformed. The spread was at 9 basis points, from 16 basis points a week ago.

Slump in Orders

Bonds stayed lower even as a report yesterday showed industrial orders declined the most in more than six years in June. Orders at factories in the 15-nation euro area fell an annual 7.4 percent, the most since December 2001, the European Union statistics office said. Excluding transport, orders slipped 1.5 percent. Economists forecast a 6.3 percent drop in total orders, according to the median of 10 estimates in a Bloomberg survey.

Outgoing European Central Bank council member Klaus Liebscher said the euro-area economy is unlikely to slide into a recession, Reuters reported Aug. 21, citing an interview.

While growth is slowing and will come in at the ``lower end'' of the ECB's 1.5 percent to 2.1 percent projection this year, ``I am far from saying the euro area is in a recession or going into a recession,'' Liebscher was cited as saying.

Liebscher, who retires as head of Austrian central bank at the end of August, said July's 4 percent inflation rate is ``worrisome.''

Growth Signs

Bunds had their biggest drop in more than a month on Aug. 21 after an index of manufacturing in the euro-region economy unexpectedly rose this month. Royal Bank of Scotland Group Plc's composite index was at 48, from 47.8 in July, as the manufacturing component gained. Economists in a Bloomberg survey forecast a drop to 47.7. The factory index climbed to 47.5 from 47.4 in July, while the services index slipped to 48.2 from 48.3.

Traders have reduced bets the ECB will lower interest rates this year to stimulate economic expansion. The implied yield on the December Euribor futures contract gained 2 basis points this week to 5.06 percent.

The European Union said Aug. 14 gross domestic product fell 0.2 percent in the second quarter. Separate data last week showed the German and French economies shrank.

The central bank left its main interest rate at 4.25 percent on Aug. 7 while ECB President Jean-Claude Trichet said that growth will be ``particularly weak'' through the second and third quarters.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net