European Bonds Post Best Month Since 1986 as Price-Growth Slows

By Lukanyo Mnyanda

Nov. 29 (Bloomberg) -- European government bonds posted their best month in at least 22 years as a report showing inflation decelerated to the slowest pace in more than a year added to signs the region’s economic slump is deepening.

The bonds handed investors a 3.7 percent return in November, according to Merrill Lynch & Co.’s EMU Direct Government index. That’s the most since at least 1986, when Merrill started compiling the data. Ten-year bunds climbed this month as the region slipped into a recession for the first time since the euro’s debut in 1999. A European Union estimate yesterday showed the inflation rate fell by the most in almost two decades.

“Based on the economic outlook, the sentiment remains positive for bonds,” said Karsten Linowsky, a fixed-income strategist in Zurich at Credit Suisse Group AG, Switzerland’s second-largest bank. “This bullish sentiment could prevail for some time.”

The yield on the 10-year bund, Europe’s benchmark government security, fell five basis points to 3.25 percent yesterday, taking its drop in November to 65 basis points. That’s the most since February 1989, when Bloomberg started compiling the data. The 3.75 percent security due January 2019 rose 0.38, or 3.8 euros per 1,000-euro ($1,272) face amount, to 104.23.

The yield on the two-year note slipped eight basis points to 2.15 percent, leaving it 39 basis points lower this month. The yield didn’t drop for five straight months since October 2001. Yields move inversely to bond prices.

Investors should favor 10-year bunds amid speculation inflation will slow, Linowsky said. The German bund yield may drop to 3 percent and the two-year note may yield between 2 percent and 2.1 percent by March, he predicted. That’s more bullish than the median forecasts of 3.57 percent and 2.24 percent, according to analysts’ predictions compiled by Bloomberg.

Stock Losses

Bonds surged this year as the U.S. housing slump pushed up the cost of credit globally and caused stock markets to tumble, prompting central banks around the world to cut interest rates. The world’s biggest financial companies have incurred almost $1 trillion in writedowns and losses since the start of last year. The Dow Jones Euro Stoxx 50 Index, a benchmark for the euro region, dropped about 20 percent since the end of September.

Inflation in the 15-nation economy slowed to 2.1 percent this month, from 3.2 percent in October, the EU’s statistics office in Luxembourg said yesterday. The drop is the biggest since at least 1991.

Two-year yields fell to within about 12 basis points of a record low on Nov. 20 as investors bet the contracting economy will check consumer-price growth and give the European Central Bank room to lower borrowing costs next month.

Noyer’s View

The ECB wouldn’t rule out the chance of further interest- rate cuts as price pressures ease, policy maker Christian Noyer told Nikkei newspaper. Inflation in the region will stay below 2 percent throughout 2009 because of falling commodity prices and slowing growth, Noyer was cited as saying Nov. 27.

The difference in yield between German and French 10-year bonds was within three basis points of the widest since the euro’s introduction in 1999 as investors sought the safest assets. It was at 42 basis points yesterday, from 45 basis points on Nov. 24, which was the most since 1999.

Policy makers lowered their main refinancing rate by 100 basis points since Oct. 8, to 3.25 percent, and will cut it again by at least 50 basis points on Dec. 4, according to a Credit Suisse Group AG index based on overnight index-swap rates. The Frankfurt-based central bank has a 2 percent inflation ceiling.

Treasury, Gilt Returns

Bonds in the U.S. and the U.K. returned about 5 percent in November as the specter of a recession and falling stock markets pushed investors to fixed-income government debt, Merrill’s Treasury Master and gilt indexes showed.

Investors should buy U.K. inflation-protected bonds because the “unprecedented” policy response to the looming recession will revive the economy by 2010, rekindling consumer-price increases, HSBC Holdings Plc analysts said. The Bank of England cut its main interest rate by 150 basis points to 3 percent on Nov. 6 to limit the fallout from the financial crisis.

The U.K. breakeven rate, a gauge of inflation expectations as measured by the difference in yield between five-year regular bonds and index-linked debt, has been negative for more than a month, suggesting investors are betting the economic slump will lead to deflation.

The five-year French breakeven rate, considered the benchmark for Europe, was at 45 basis points today, compared with 37 basis points on Nov. 26, which was the lowest since at least 2004. The so-called breakeven rate reflects inflation rate traders expect over the life of the security.

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