Nov. 17 (Bloomberg) -- The looming global recession is prompting investors to shift funds into European government bonds at the expense of Treasuries on speculation policy makers have more scope to cut interest rates than the Federal Reserve.

An investor who bought $10 million of the debt in June would have an average profit of about $678,000, compared with $380,000 if the money went into Treasuries, Merrill Lynch & Co. index data show. Even with those gains European fixed-income assets may be a bargain, with two-year German bunds yielding 0.95 percentage points more than Treasuries. They typically yield 0.15 percentage point less than U.S. debt, based on data over the past decade.

Citigroup Inc. in New York forecasts the difference in yields may disappear by April as the European Central Bank lowers borrowing costs and the Fed approaches the end of its cycle of reductions. The ECB's main rate of 3.25 percent and the Bank of England's 3 percent target compare with 1 percent in the U.S.

``You have seen the economic data all through Europe decelerate rather dramatically,'' said Nic Pifer, head of global fixed income at Riversource Investments in Minneapolis, who helps oversee $4.6 billion. ``You still have more room for the ECB to ease than the Fed does, so on the face of it that should be better for bonds in Europe.''

RiverSource is ``overweight'' European bonds, meaning the firm holds a greater percentage of the debt than benchmark indexes, and is ``underweight'' Treasuries. The firm has investments in U.K. debt maturing in two to seven years, and has added similarly-dated European bonds, Pifer said.

`New Cyclical Period'

German debt has returned 3 percent, including prices gains and reinvested interest, since Oct. 1, topping the 1 percent for Treasuries, according to Merrill Lynch indexes. In France, bonds have gained 3 percent, while U.K. gilts earned 2.3 percent.

European government notes rallied for eight weeks, driving down the yield on the benchmark 4 percent bund due September 2010 to 2.16 percent from 4 percent. The yield on the 1.5 percent Treasury note maturing October 2010 fell by a smaller amount, declining to 1.21 percent from 2.17 percent.

``We've entered a new cyclical period of outperformance for Bunds relative to Treasuries,'' said Gregor MacIntosh, a money manager in Edinburgh at Standard Life Investments Ltd., which has about $265 billion in assets. ``Any potential recovery in the European economy is likely to take far longer to emerge.''

Standard Life has a ``strategic'' long position in bunds versus Treasuries in a bet that the German securities will gain more over the next two years, MacIntosh said. A long position benefits when the bonds rally.

Early Moves

European bonds haven't outperformed Treasuries on an annual basis since 2005, when the U.S. raised interest rates at each of its eight policy meetings and the ECB increased its target once.

Merrill Lynch's EMU Direct Government Index gained 5.39 percent that year, compared with 2.81 percent for its U.S. Treasury Master Index. Since then the EMU index has returned 7.35 percent, versus 19.4 percent for the Treasury index.

Investors attribute the outperformance of Treasuries in the first half of the year to early moves by the Fed to try to stem the spreading subprime mortgage contagion. The Fed began the first of nine cuts in September 2007, while the ECB began easing just six weeks ago, cutting rates two times, to 3.25 percent from a seven-year-high of 4.25 percent.

``Europe lagged behind when it came to action -- for a long time they underestimated the systemic crisis,'' said Thomas Kressin, a senior vice president in Munich at Pacific Investment Management Co. ``Treasuries outperformed when the Fed started cutting and the ECB was standing firm. Now it's the opposite.''

Pimco's Strategy

Pimco, which runs the world's biggest bond fund, favors two-and three-year European notes, Paul McCulley, a managing director at the Newport Beach, California-based firm, said in a Bloomberg Radio interview on Nov. 13.

Unprecedented demand for cash and cash equivalents as credit-market related losses approach $1 trillion has helped keep Treasuries from falling even while the U.S. government sells more of the debt to finance bank bailouts. Rates on one- month Treasury bills fell to a record low of 0.04 percent on Nov. 12.

``We expect the lack of risk taking to continue and perhaps heat up into the end of the year,'' Michael Pond, an interest- rate strategist at Barclays Capital Inc in New York, said. ``That should increase the flight to liquidity in the front of the Treasury market.''

Two-year Treasury yields will fall below 1 percent by year- end, according to Pond, whose firm is one of the 17 primary dealers of U.S. government securities that trade with the Fed.

First Recession

The flight to risk-free Treasuries helped the dollar strengthen 16 percent against the euro this year, diminishing the appeal of European assets to U.S. investors.

Further ECB rate cuts may be needed after the euro-zone economy fell into its first recession in 15 years, contracting 0.2 percent in both the second and third quarters, the European Union's Luxembourg-based statistics office said Nov. 14. Espoo, Finland-based Nokia Oyj, the world's largest maker of mobile phones, said Nov. 14 that industrywide handset sales will be lower this year than previously anticipated.

Fed Chairman Ben S. Bernanke said at a panel discussion hosted by the ECB in Frankfurt on Nov. 14 that the global economy faces ``challenges.'' ``For this reason, policy makers will remain in close contact, monitor developments closely and stand ready to take additional steps should conditions warrant.''

`In a Corner'

Europe's central bank will reduce borrowing costs to 2.25 percent by the end of the third quarter of 2009, according to the weighted average forecast of 33 economists surveyed by Bloomberg. The Fed will cut to 0.75 percent, a separate survey shows.

Citigroup analysts Shyam Devani in London and Tom Fitzpatrick in New York are more pessimistic, forecasting the ECB may slash rates to 1 percent by the end of March. That will allow the yield on the 2-year bund to converge with the yield of the comparable Treasury, they said.

``The ECB will likely find itself in a corner, like the Fed earlier in the year, which will lead to some serious action,'' Devani said.

ECB President Jean-Claude Trichet said in an interview with Bloomberg Television in Frankfurt Nov. 14 that the bank's ``considerable'' policy action will help restore confidence in Europe's contracting economy. He described the economy as being in a period of ``stagnation with negative figures'' after the region slipped into its first recession in 15 years.

Confidence Survey

A rising supply of debt may work in favor of European bonds. The U.S. will issue at least $1.5 trillion in debt in 2009, outpacing the 880 billion euros ($1.1 trillion) in Europe and pressuring Treasury yields higher, according to strategists at Edinburgh-based Royal Bank of Scotland Group Plc, the U.K. bank that agreed to that government's biggest bailout.

Treasuries will fall over the next six months as the U.S. increases borrowing, while debt in Europe, Asia and Latin America rallies, a monthly survey of Bloomberg users showed last week.

Participants turned bearish on 10-year Treasuries notes this month for the first time since March, while remaining bullish on government debt from France, Germany, Italy, Spain, Switzerland and the U.K., according to the Bloomberg Professional Global Confidence Index. The poll questioned 3,550 Bloomberg users.

``The market is underestimating how much the ECB will have to cut interest rates,'' said Ralf Preusser, a London-based fixed-income strategist for Deutsche Bank AG, Germany's largest lender. ``I still see a lot of value in bunds relative to Treasuries.''

To contact the reporters on this story: Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: November 17, 2008 11:47 EST