Nov. 1 (Bloomberg) -- European two-year government notes posted the biggest monthly advance since September 1992 amid speculation the region's central bank will lower interest rates next week to head off a recession in the 15-nation economy.

The gains sent the difference in yield between two- and 10- year bonds to the most in almost four years as shorter-dated notes, more sensitive to expectations for rates, outperformed. European Central Bank policy maker Guy Quaden told L'Echo in an interview published yesterday a drop in borrowing costs ``is possible'' in the region.

``The market's come a long way, but there's a lot more to go,'' said Nick Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets. ``The market has significantly shifted its views on the ECB. The rapidly deteriorating economic outlook points to significant rate cuts and the continued weak performance of risky assets is giving support to bunds.''

The yield on the two-year German note fell 11 basis points this past week to 2.55 percent by late yesterday in London. The yield slid 92 basis points since Sept. 30, for its fourth monthly loss. The 4 percent bond due September 2010 rose 0.16, or 1.6 euros per 1,000-euro ($1,276) face amount this week, to 102.57.

The yield on the 10-year bund climbed 14 basis points to 3.89 percent, paring its decline since Sept. 30 to 12 basis points. Yields move inversely to bond prices.

Demand for Safety

The two-year note, which hasn't risen for four consecutive months since March 2004, surged as concern the credit-market meltdown will push the global economy into a recession sapped demand for higher-yielding assets. Equities around the world slumped, pushing the MSCI World Index of stocks to its worst four-week loss on record.

The spread between two- and 10-year yields widened to 134 basis points, near the most since December 2004, steepening the so-called yield curve, a chart of bonds of different maturities.

Ten-year German bunds yielded less than comparable U.S. Treasuries for the first time this week since November 2007. Ten-year U.S. Treasury notes yielded 5 basis points more than bunds.

The yield spread between bunds and other debt of the same maturity in the region is the widest since 1997 as investors sought the most liquid of government bond markets. The gap between bunds and their Italian counterparts widened to 127 basis points yesterday. The difference with Spanish 10-year debt was 69 basis points as the country's economy contracted in the third quarter for the first time since 1993.

'Punishing Countries'

``The market seems to be punishing those countries that have adopted large-scale rescues for the banking sector,'' Stamenkovic said. ``Italy always seems to be on the firing line as well because of its poor historical record and fiscal deficits.''

Gains for bonds may be limited because European government debt sales may reach 750 billion euros ($955 billion) next year as larger budget deficits and the cost of bank recapitalization plans boost issuance, according to analysts at UBS AG in London.

``We expect most of the issuance to occur'' with shorter- dated notes, Meyrick Chapman, a fixed-income strategist in London at UBS AG, wrote in a client note. ``However the weight of issuance, combined with a lack of buying interest for longer- dated maturities will result in considerably higher real yields'' for longer-dated notes.

Bonds also gained after a government report showed consumer-price growth in the region slowed this month. The inflation rate fell to 3.2 percent, from 3.6 percent in September, the European Union's statistics office in Luxembourg said yesterday. That matched the median estimate of 27 economists surveyed by Bloomberg.

Retail Sales

Retail sales in Germany, Europe's largest economy, fell more than economists expected in September. Sales slipped 2.3 percent from August, the Federal Statistics Office said yesterday. Economists forecast a drop of 1 percent, the median of 15 estimates in a Bloomberg survey showed.

Inflation in the euro area was last below 3 percent a year ago and has been above the ECB's 2 percent ceiling in every month since September 2007.

The ECB participated in a coordinated interest-rate reduction by global central banks on Oct. 8 to prevent the collapse of the global financial system, reducing its benchmark rate by half a point to 3.75 percent. The Bank of Japan yesterday lowered its main rate to 0.3 percent to spur growth.

Policy makers meet Nov. 6, when they will probably cut the region's main refinancing rate a half point to 3.25 percent, according to a Bloomberg survey of 26 economists.

The implied yield on the three-month Euribor futures contract due in January fell 20 basis points this past week to 3.42 percent, suggesting traders are increasing bets borrowing costs have further to fall.

European bonds outperformed Treasuries this month, handing investors a 2 percent return, compared with 0.1 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct and Treasury Master indexes.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

Last Updated: November 1, 2008 03:30 EDT