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European bonds may drop in weeks ahead

European bonds may fall in coming days, pushing two-year note yields toward four-week highs, on expectations inflation won't slow quickly enough for the European Central Bank to cut its interest rate soon.

The ECB "will want to avoid surprising the market," so the rate won't be cut in coming weeks, said Rajeev Demello, who manages 3.5 billion euros (US$2.9 billion) as head of fixed income at Pictet & Cie in Paris. He's buying 30-year bonds; the central bank is "not sending the signals" that would indicate it's about to boost shorter-dated bonds by lowering borrowing costs, he said.

The yield on the German two-year note fell 4 basis points to 4.30 percent Friday and climbed 7 basis points in the week. The 10- year benchmark bund yield fell 3 basis points to 5.07 percent, dropping just 1 basis point in the previous five days. The September bund futures contract rose 0.42 to 106.76.

Faster inflation is making it difficult for ECB policy-makers to reduce its borrowing cost. Consumer prices rose 3.4 percent in May, keeping inflation above the bank's ceiling of 2 percent for more than a year. An accelerating inflation rate hurts bonds because it reduces the value of their fixed interest payments.

Investors don't anticipate lower rates by September, judging by the interest-rate futures market. The rate on the Euribor contract for September fell 3 basis point to 4.29 percent, 16 basis points less than the current three-month lending rate.

Still, Ronald Balk, who helps manage US$26 billion at Robeco Groep in Rotterdam, said evidence of slowing growth will spur the ECB to lower rates even though "inflation will climb." He expects yields on longer-dated bonds to keep rising, and is buying shorter-dated bonds.

At the ECB's meeting Thursday, rates were left unchanged at 4.5 percent. Bank President Wim Duisenberg said current monetary policy is "appropriate to bring inflation back in line" with price stability. Still, it's likely the pace of inflation will drop below 2 percent next year, he said.

The bank has forecast a growth rate this year of 2 percent to 2.5 percent. Confidence among executives and consumers fell for the fifth straight month, reports this week showed.

German bonds maturing in one year or more have returned 1.46 percent since the start of the year. US Treasuries have performed better, returning 1.94 percent. UK gilts, in comparison, have lost 1.1 percent.

The 30-year German bond has lost 1.4 percent year to date, underperforming the equivalent US bond, which has returned 0.7 percent. The premium investors demand to buy the Treasury bond over the German one is currently 9 basis points. It reached this year's high of 28 basis points on April 27.

"I'm a fan of 30-year bonds," because yields will decline in coming weeks, said Pictet's Demello. He said they're "better value," while the "two-year [bond] is expensive."

The final figures for German June consumer prices will be published next week. In May, EU-harmonized prices rose by 0.6 percent and advanced 3.6 percent in the year before.

German industrial output numbers, due Monday, will likely show a decline in May of 0.5 percent, and an annual drop of 0.9 percent. The month before, output in the largest economy in the 12-country euro region fell 1.4 percent and declined 0.4 percent from the same period a year previous. Preliminary French consumer prices will be released on Thursday.
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