European Bonds Rise as Regional Services, Manufacturing Shrink

By Andrew MacAskill

Oct. 25 (Bloomberg) -- European government bonds climbed as stocks tumbled and an industry survey showed the region's manufacturing and service industries shrank for a fifth month in October as the 15-nation economy slides toward a recession.

Two-year German notes advanced for a fifth week, pushing yields to the lowest level in almost three years, as the MSCI World Index of equities lost 9 percent. U.S. Treasuries and U.K. government bonds also gained after more than $10 trillion was wiped off equity values so far this month, fueling investor demand for the safest assets.

``This will keep the entire government bond universe well supported,'' said Kornelius Purps, a fixed-income strategist in Munich at Unicredit Markets and Investment Banking, a unit of Italy's largest lender. ``This is a truly ugly scenario and once again on a Friday we are just one step away from the cliff.''

The yield on the two-year German note slipped 11 basis points to 2.67 percent by 5 p.m. in London yesterday, extending its drop in the week to 27 basis points. The 4 percent note due September 2010 rose 0.19, or 1.9 euros per 1,000-euro ($1,259) face amount, to 102.38.

The yield on the 10-year German bund, Europe's benchmark government security, fell 25 basis points in the past five days to 3.76 percent, the steepest decline since the period ended Aug. 1. Yields move inversely to bond prices.

Equities slumped around the world on concern a global recession will erode corporate earnings. Europe's Dow Jones Stoxx 600 Index slid 6 percent and the Dow Jones Industrial Average lost 3.4 percent.

The euro headed for a 5 percent weekly decline against the dollar and traded at the weakest in six years versus the yen.

Bond Returns

European bonds outperformed U.S. Treasuries this month, handing investors a 2.2 percent return, compared with 1.6 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct and Treasury Master indexes.

Royal Bank of Scotland Group Plc's composite gauge for Europe's manufacturing and services fell to the weakest since the survey began in 1998. Italian business confidence slipped to the weakest in 15 years, a separate report yesterday showed.

Royal Bank of Scotland said yesterday its composite index for Europe's manufacturing and services fell to 44.6, from 46.9 in September. The Isae Institute's index of business sentiment in Italy, the euro region's third-largest economy, fell to 77.7 this month from 81.8 in September, the Rome-based research center said.

European government bonds extended gains yesterday after a report showed the U.K. economy contracted more than forecast in the third quarter. Gross domestic product shrank 0.5 from the second quarter, the Office for National Statistics said.

`Economic Slowdown'

``This hasn't helped sentiment and was more confirmation that in Europe we are moving to an economic slowdown,'' said Wilson Chin, a fixed-income strategist at ING Bank NV in Amsterdam.

The International Monetary Fund on Oct. 7 predicted growth in the 15 countries sharing the euro would slow to 0.2 percent next year, the weakest since the single currency began trading in 1999, from 1.3 percent this year.

The cost of borrowing in dollars overnight in London increased as the likelihood of a global recession spurred banks to hoard cash. The London interbank offered rate, or Libor, that banks charge for such loans climbed 7 basis points to 1.28 percent yesterday, the British Bankers' Association said.

Spreads Widen

Two-year yields, which are most sensitive to the outlook for interest rates, have slipped more than a percentage point this month as widening credit- and stock-market losses encouraged investors to buy shorter-dated debt, seen as the safest assets.

The difference in yield, or spread, between two- and 10-year notes widened to 108 basis points yesterday, from 40 basis points a month ago. A steepening of the so-called yield curve suggests investors are increasing bets on lower rates.

``This is a combination of safe-haven flows and people looking for the European Central Bank to cut rates aggressively,'' said Charles Diebel, head of European interest- rate strategy in London at Nomura International Plc. The two-year note is ``pretty rich at these levels and people are looking for too much monetary easing too soon.''

ECB council member Ewald Nowotny said the bank has room to lower borrowing costs, Reuters reported yesterday, citing an interview with CNBC. The ECB cut its main refinancing rate by half a percentage point to 3.75 percent on Oct. 8 in concert with other central banks around the world.

Investors should continue buying shorter-dated European bonds because the yield curve may steepen further, according to a team of analysts from ING.

``On the curve we maintain a preference for steepeners, and especially on the two/10-year segment,'' strategists including Padhraic Garvey, head of investment-grade debt strategy in Amsterdam at ING, wrote in a client note yesterday.

U.K. government bonds gained by the most this past week since 1999. The yield on the 10-year gilt fell 11 basis points to 4.36 percent after a report showed Britain's economy contracted more than forecast in the third quarter, bringing the nation to the brink of a recession.

To contact the reporter on this story: Andrew MacAskill in London at amacaskill@bloomberg.net