June 30 (Bloomberg) -- European government bonds fell, with the German two-year note dropping the most in three weeks, after inflation rose to the highest level in more than 16 years, boosting the case for policy makers to raise interest rates.

The decline snapped a two-day gain and pushed the yield on the two-year note up by the most since June 5, with the price posting its biggest quarterly slide in at least 17 years. A government report showed the inflation rate in the 15-nation euro region rose to 4 percent from 3.7 percent in May. The figure was ``of deep concern,'' European Union Economic and Monetary Affairs Commissioner Joaquin Almunia said.

``A rate increase this week looks like a done deal,'' said Christoph Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt. ``It's likely that policy makers will signal that one rate hike might not be enough. Short-dated bond yields have scope to rise further.''

The yield on the two-year note climbed 16 basis points to 4.59 percent by 5:43 p.m. in London, leaving it 117 basis points higher in the quarter, the biggest gain since 1990. The price of the 4.75 percent security due June 2010 slid 0.30, or 3 euros per 1,000-euro ($1,573) face amount, to 100.27.

Economists had forecast a 3.9 percent inflation rate, according to the median of 38 estimates in a Bloomberg survey.

The one-day increase in yield today was the biggest since European Central Bank President Jean-Claude Trichet signaled the bank may lift rates as soon as July. The two-year yield will rise to 4.8 percent in three months as the inflation outlook worsens, Rieger said.

Breakeven Rate

The yield on the 10-year bund, Europe's benchmark government security, jumped 9 basis points to 4.62 percent.

The French five-year breakeven rate, a market gauge of inflation expectations, advanced to 270 basis points, the highest on record, following the inflation report.

All but one of 58 economists surveyed forecast the ECB will lift its benchmark rate by 25 basis points to 4.25 percent to battle inflation. One economist predicts no change. An increase would be the first change in borrowing costs in a year. The ECB announces its decision on July 3.

Crude oil surpassed $143 a barrel for the first time on speculation the dispute over Iran's nuclear program may disrupt supply from OPEC's second-largest producer. Prices have doubled in the past year.

Inflation is a ``clear and present danger,'' said Malcolm Knight, general manager of the Bank for International Settlements in Basel, Switzerland.

Inflation Versus Growth

``At present most forecasters think that the recent rise in headline inflation in industrial countries represents a temporary blip,'' Knight said today in a speech after the BIS annual general meeting. ``But we cannot be entirely confident about this reassuring assessment.''

The world's central banks should increase interest rates even as economic growth slows because taming inflation is the more immediate problem, the BIS said.

Bonds stayed lower after a measure of U.S. business activity for June unexpectedly rose. The National Association of Purchasing Management-Chicago said its business index increased to 49.6 this month, signaling a slower pace of contraction, from 49.1 in May. A reading of 50 is the dividing line between growth and contraction.

German bonds underperformed U.S. Treasuries in the first half. Investors holding the European benchmark security gained 0.42 percent in the period, compared with an advance of 2.14 percent for Treasuries, according to Merrill Lynch & Co.'s Global Sovereign Index.

Bond Spreads

Ten-year bunds yielded 65 basis points more than their U.S. counterparts, the most since September 2002, on speculation that the ECB, whose sole mandate is to fight inflation, will raise borrowing costs, while the Fed keeps rates on hold.

The yield difference, or spread, between two- and 10-year notes narrowed to 2 basis points from 8 basis points last week. The flatter curve suggested investors raised bets that policy makers will need to raise interest rates to curb price pressures.

The supply outlook for July will be supportive for bonds in the euro region, according to ING Bank NV. Governments will issue 55 billion euros next month, which will be exceeded by 70 billion euros in redemption payments, the bank estimated.

Governments in the euro region, the biggest sovereign bond market in the world, have issued about 365 billion euros of bonds in the first half, according to ING estimates.

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

Last Updated: June 30, 2008 12:44 EDT