Aug. 15 (Bloomberg) -- European government bonds rose for a third week as evidence the region's economy is shrinking made it less likely the European Central Bank will raise interest rates.

The gains sent yields to the lowest level in 12 weeks. The European Union said yesterday gross domestic product fell 0.2 percent in the second quarter. Separate data showed the German and French economies shrank. Bonds stayed higher after a private poll today showed optimism about Germany's economic outlook fell in June to the lowest level in more than five years.

``We expect the euro-area economy to cool further and we may see the ECB preparing to cut rates,'' said Niels From, chief analyst in Copenhagen at Nordea Bank AB, Scandinavia's biggest lender. ``Risks for the economy are still on the downside and any rise in yields will be temporary.''

The yield on the 10-year German bund, Europe's benchmark government security, fell 5 basis points to 4.15 percent, the lowest level since May 14, by 4:42 p.m. in London. It dropped 11 basis points this week. The price of the 4.25 percent bond due July 2018 gained 0.86 this week, or 8.6 euros per 1,000-euro ($1,469) face amount, to 100.77. The yield on the two-year German note slipped 4 basis points to 3.98 percent.

The 10-year yield may drop to 4 percent in 12 months, while that on the two-year note may slip to 3.7 percent, From said.

Traders have reduced bets the ECB will raise interest rates a second time this year, with the implied yield falling 3 basis points since Aug. 1 to 5.03 percent.

ECB Outlook

UBS AG, the world's second-biggest foreign-exchange trader, expects the ECB to keep interest rates on hold through the rest of 2008, changing an earlier prediction for an increase in borrowing costs in September. Economists at the Zurich-based bank said growth slowed ``more rapidly than initially expected'' and policy makers will lower rates in the first quarter of next year, according to a note e-mailed to investors today.

The difference in yield, or spread, between 10-year bunds and similar-maturity U.S. Treasuries was at 31 basis points today, down from 41 basis points July 31, reflecting falling investor expectations that the ECB will lift rates.

Analysts and politicians are talking down the economy and this may have ``a negative impact on business and consumer sentiment,'' the International Herald Tribune cited ECB policy maker Juergen Stark as saying yesterday.

German Confidence

The share of people who see Germany in an economic decline rose to 45 percent, from 26 percent in June, according to a Forschungsgruppe Wahlen poll for ZDF television. Fourteen percent of respondents said the economy is in an upswing, down from 26 percent in June, ZDF said in an e-mailed statement.

Euro-region growth will be ``particularly weak'' through the second and third quarters, ECB President Jean-Claude Trichet said Aug. 7, when the central bank kept its main interest rate at 4.25 percent, the highest level in seven years.

The Ifo research institute will cut its forecast for German economic growth this year to about 2 percent from 2.4 percent, Wirtschaftswoche reported, citing an interview with Hans-Werner Sinn, Ifo's president.

Bonds rallied yesterday as the EU said the region's economy contracted for the first time since the introduction of the euro in 1999 during the second quarter. Another report showed German GDP fell an adjusted 0.5 percent from the first quarter, when it rose a revised 1.3 percent.

Breakeven Rate

Index-linked bonds signaled investors are reducing their inflation expectations, with the difference in yield between the five-year French inflation-protected note and its regular counterpart falling 2 basis points today to 2.19 percentage points. The difference, the so-called breakeven rate, was at a record 2.83 percentage points on July 3.

Gains by bonds may be limited as some investors bet yields don't reflect the risk of the ECB raising rates to curb inflation, which quickened to 4.1 percent last month, more than twice the bank's 2 percent ceiling.

``It's too early to completely price out the risk of the ECB raising rates,'' said Andre de Silva, global deputy head of fixed-income strategy in London at HSBC Holdings Plc, Europe's biggest bank by market value. ``Inflation is stubbornly high and we might see a flatter curve.''

The 10-year bund yielded 17 basis points more than the two- year note, which is more sensitive to the interest-rate outlook, a 4 basis-point narrowing of the spread since Aug. 8.

There isn't any reason to ``dramatize'' the economic situation in Europe, though inflation may not slow as the economy cools, Stark told the Herald Tribune in an interview published yesterday. Fellow ECB official Axel Weber said yesterday there are ``upside risks to price stability that require very close monitoring.''

European government bonds returned 2.3 percent this year, while U.S. debt earned 3.3 percent, according to Merrill Lynch & Co.'s EMU Direct Government and U.S. Treasury Master indexes.

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

Last Updated: August 15, 2008 12:18 EDT