European Bonds Post Biggest Weekly Advance Since 1992 on Growth

By Anchalee Worrachate

Dec. 20 (Bloomberg) -- European bonds posted their biggest weekly gain in 16 years after a government report showed German producer prices fell last month by the most since records began in 1949 as the economy slipped into a recession.

Gains sent the yield on German two-year notes to a record low. The 10-year bund closed below 3 percent for the first time since Bloomberg records began in 1989 on speculation the European Central Bank will cut borrowing costs to spur growth and head off deflation. ECB policy makers lowered their main rate by 75 basis points to 2.50 percent on Dec. 4.

“It’s definitely not paying investors much to fight the bond rally that we’ve seen over the past three-four months,” said Laurent Fransolet, head of European fixed-income strategy at Barclays Capital in London. “Central banks have been cutting interest rates and will continue to cut them aggressively.”

The two-year yield fell three basis points to 1.825 percent by 6 p.m. in London yesterday, the lowest level since at least 1990, when Bloomberg records began. The 2.25 percent security due December 2010 rose 0.04, or 40 euro cents per 1,000-euro ($1,392) face amount, to 100.81. Yields are down 42 basis points from last week, the most since September 1992.

The yield on the 10-year bund, Europe’s benchmark government security, climbed three basis points to 3 percent, leaving it 29 basis points lower in the week, also the most since September 1992. Yields move inversely to bond prices. Fransolet recommended that investors go long 10-year German bonds, or bet that they will rise in price.

Producer prices in Europe’s largest economy slipped 1.5 percent from October when they were unchanged, the Federal Statistics Office said yesterday.

This Year’s Returns

German bonds returned almost 12 percent this year, compared with 11 percent for gilts and 15 percent for U.S. Treasuries, according to Merrill Lynch & Co.’s German Federal Government, U.K. Gilts and U.S. Treasury Master indexes. By comparison, the Dow Jones Stoxx 600 Index slid 46 percent. Oil fell 63 percent.

The decline in producer prices added to signs inflation in Europe’s largest economy is waning, giving the ECB more scope to reduce interest rates. German consumer-price growth slowed to 1.4 percent in November, from 2.5 percent, falling below the ECB’s price stability threshold for the first time since February 2007, a government report Dec. 17 showed.

Falling prices “will put upward pressure on real interest rates,” said Frederik Ducrozet, an economist in Paris at Credit Agricole SA. “In order to keep real interest rates close to zero and monetary conditions accommodative, the ECB could bring its rate down to 1.50 percent in the second quarter.” Real interest rates subtract the effect of inflation.

Bank of Japan

The world’s biggest central banks are lowering borrowing costs to combat the worst economic slump since the Great Depression. The Bank of Japan cut its benchmark rate to 0.1 percent today and said it would buy corporate debt as a deepening recession chokes off funding for businesses. The Federal Reserve lowered its target rate as low as zero on Dec. 16 and pledged to buy unlimited quantities of securities.

Japanese government bonds outperformed their European counterparts. The yield difference, or spread, between 10-year Japanese bonds and German bunds widened to 174 basis points yesterday, from 170 basis points on Dec. 18.

Demand for the safest assets was also fueled by declines in stocks. The Dow Jones Euro Stoxx 50 Index, a benchmark for the region, fell for a second week in three.

Risk Appetite

Gains in bonds may be limited as the VIX, an indicator of market volatility, fell to the lowest level in 2 1/2 months after the Fed’s rate cut helped calm equity-market swings, according to BNP Paribas SA. The VIX, as the Chicago Board Options Exchange Volatility Index is known, fell to 47.34, from 49.84 yesterday and 54.28 a week ago. The index measures the cost of using options as insurance against declines in the S&P 500 and typically falls as stocks rise.

“The rebound of risk appetite could prevent government bonds from rallying further near term,” BNP wrote in a note to clients today. “The VIX is back to the bottom of past 2 months’ range. A lasting break through the 50 area would be positive sign for normalization trades in early 2009.”

Some technical indicators also signaled gains in bonds this week may be overdone. The German bund’s 14-day relative strength index, a comparison of the magnitude of gains and losses, was at 71.2, above the 70 level that signals a change in direction may be imminent.

Governments around the world are raising borrowing to fund bailouts and revive their economies. France said yesterday it plans to sell 145 billion euros of medium- and long-dated bonds next year. Germany said Dec. 18 it will issue 323 billion euros of debt next year, the most since the end of World War II. The issuance will comprise 147 billion euros in bonds and 174 billion euros of shorter-dated securities.

To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net