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BLBG: European Notes Fall as Stocks Recover After Australia Rate Cut
By Lukanyo Mnyanda

Oct. 7 (Bloomberg) -- European bonds fell as European stocks and U.S. equity futures rose after Australia's central bank slashed interest rates more than economists expected, reducing appetite for the safest assets.

The declines drove the yield on the two-year German note up from the lowest level since March amid speculation other countries will follow the Reserve Bank of Australia's 1 percentage-point cut in its benchmark rate to unlock credit markets. The TED spread, a gauge of cash scarcity among banks, dropped from a record and the cost of insuring company bonds against default fell.

``Coordinated moves by central banks to restore financial stability are looking increasingly likely and the market is taking a pause,'' said Nick Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets. ``Underlying sentiment remains nervous.''

The yield on the two-year note jumped 9 basis points to 3.14 percent as of 8:21 a.m. in London. The 4 percent note due September 2010 dropped 0.16, or 1.6 euros per 1,000-euro ($1,359) face amount, to 101.57. The yield on the 10-year bund, Europe's benchmark government security, was 4 basis points higher at 3.79 percent.

The likelihood the world's largest economies are on the brink of a recession is pushing central banks toward cuts in borrowing costs to revive growth. Australia's reduction was its biggest since a recession in 1992. The Federal Reserve may lower its target rate for overnight bank loans by three-quarters of a percentage point at its Oct. 29 meeting, interest-rate futures show. European Central Bank President Jean-Claude Trichet said last week policy makers considered a rate cut.

Buy Short-Dated Notes

Investors should favor Europe's shorter-dated government notes because the ECB is likely to cut rates before year-end, Stamenkovic said. The ECB kept the main refinancing rate at 4.25 percent on Oct. 2.

Bonds fell as Europe's Dow Jones Stoxx 600 Index jumped 2.6 percent, after tumbling yesterday the most since 1987. Futures on the Standard & Poor's 500 Index rose 2 percent, while contracts on the Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings declined 20 basis points to 617, according to JPMorgan Chase & Co., indicating an increase in the perception of credit quality.

Policy maker Michael Bonello said yesterday the ECB plans a ``prudent approach'' when weighing the need for rate cuts as the credit crisis clouds the outlook for the economy.

``We will be assessing the information as it comes in and take a decision at the next meeting after due deliberation,'' Bonello, who heads Malta's central bank, said in an interview in Valletta. ``Particularly in these uncertain times, that is the most prudent approach to take.''

Probability Index

Policy makers will probably cut by at least a quarter point next month, according to a Credit Suisse Group index of derivatives. The implied yield on the December Euribor futures contract dropped 2 basis points to 4.51 percent today, the lowest level since May, in a further sign traders expect borrowing costs to fall.

Two-year German notes yielded 62 basis points less than 10- year bunds today, near the widest spread since March 17. The shorter-dated securities, which are more sensitive to the interest-rate outlook, yielded 21 basis points more than bunds as recently as June 6.

The yield advantage of the two-year German government note over equivalent-maturity U.S. securities was at 164 basis points today, from 163 yesterday. The spread narrowed from 226 basis points on June 6, which was the most this year.

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