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BLBG: European Bonds Head for Weekly Gain as Rate-Cut Odds Increase
By Lukanyo Mnyanda

Oct. 3 (Bloomberg) -- European government bonds headed for a second weekly gain after central bank President Jean-Claude Trichet indicated policy makers may cut interest rates this year to counter a weakening economy.

Two-year notes soared yesterday, sending yields to the lowest level in more than six months, after Trichet said the European Central Bank discussed a cut in borrowing costs as it faces ``increased downside risks'' to growth. The ECB kept the main refinancing rate at 4.25 percent, as forecast by all 58 economists surveyed by Bloomberg.

``For us, like the market, Trichet's discourse laid the ground for a rate cut in November,'' Ciaran O'Hagan, a fixed- income strategist in Paris at Societe Generale SA, wrote in a client note. ``The market is unlikely to price much less than a 25 basis-point cut over coming weeks.''

The yield on the two-year note fell 5 basis points to 3.25 percent by 7:20 a.m. in London, taking its decline since Sept. 26 to 41 basis points. The price of the 4 percent note due September 2010 rose 0.08, or 80 euro cents per 1,000-euro ($1,386) face amount, to 101.38.

The yield on the German 10-year bund, Europe's benchmark government security, slipped 1 basis point to 3.92 percent, leaving it 24 basis points lower in the week. Yields move inversely to bond prices.

Bonds also gained as Asian stocks slumped, pushing the region's benchmark index to its biggest weekly drop in 13 months. The MSCI Asia Pacific Index declined 2 percent today on concern the $700 billion U.S. bank-rescue plan won't cure the seizure of the credit market anytime soon.

UBS AG, the European lender hardest hit by the credit crisis, said it will cut 2,000 more jobs from its investment bank unit.

Trichet's Views

``There is an exceptionally high level of uncertainty'' stemming from the credit-market turmoil, and as a result, ``upside risks to price stability have diminished somewhat, but have not disappeared,'' Trichet told reporters in Frankfurt yesterday.

Two-year notes yielded 64 basis points less than 10-year bunds today on bets the economic slowdown will force policy makers to cut rates by year-end. The shorter-dated securities yielded 22 basis points more than bunds as recently as June 6.

Investors increased wagers on rate cuts by the ECB and lowered their inflation expectations, with the implied yield on the December Euribor futures contract dropping 35 basis points this week to 4.80 percent.

Inflation Expectations

The difference in yield between the five-year French inflation-protected note and its regular counterpart fell 13 basis points to 1.84 percentage points yesterday, the lowest in at least 2 1/2 years. The so-called breakeven rate was at a record 2.83 percentage points on July 3.

European bonds soared this week, with two-year yields yesterday reaching the lowest level since March 20, as governments bailed out as many as five financial institutions in the U.S. and Europe battered by the freeze in short-term credit. Banks are reluctant to lend on concern more of their peers will collapse after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy two weeks ago.

European bonds outperformed U.S. Treasuries in the past three months, handing investors a 5 percent return, compared with 3.3 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct and Treasury Master indexes.

The yield advantage of the two-year German government note over equivalent-maturity U.S. securities increased 1 basis point to 164 basis points today.

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