German Two-Year Notes Decline as ECB Tender Heralds Higher Interest Rates

German two-year notes declined, pushing the yield to the highest level since May, on speculation a decline in the amount financial institutions are borrowing from the European Central Bank heralds higher interest rates.

The securities fell for a second straight day as the ECB loaned banks 111.2 billion euros ($139 billion) for six days, following a three-month tender yesterday when lenders bid for less than analysts forecast. Spanish notes fell as the nation sold 3.5 billion euros of five-year debt. Moody’s Investors Service yesterday put the country’s credit rating on review.

“It’s a money-market-driven force,” said Sean Maloney, a fixed-income strategist at Nomura Holdings Inc. in London. “With a lower supply of cash, the implication is you get upward pressure on short-term rates, hence the pressure on the two- years today.”

The yield on the two-year note advanced seven basis points, or 0.07 percentage point, to 0.67 percent as of 4:15 p.m. in London. It touched 0.71 percent, the highest level since May 10. The 0.5 percent security maturing in June 2012 fell 0.14, or 1.4 euros per 1,000-euro face amount, to 99.67.

The yield on the euribor futures contract maturing in March 2011 rose six basis points to 1.17 percent, indicating increased bets on higher borrowing costs.

ECB Lending

German government bonds returned 4.1 percent last quarter according to indexes compiled by Bloomberg and the European Federation of Financial Analysts’ Societies, as the sovereign debt crisis boosted demand for the safest fixed-income assets. The yield difference between 10- and two-year German debt fell to 188 basis points, the narrowest since December.

Concern the crisis would spread made financial institutions wary of lending to each other, complicating the ECB’s withdrawal of stimulus measures used to fight last year’s financial crisis. While the ECB no longer offers banks 12-month loans, the debt crisis forced it to reintroduce unlimited lending in three- and six-month refinancing operations and to start buying the bonds of the most indebted nations.

The ECB said yesterday it lent institutions 131.9 billion euros for three months, compared with the median forecast of 200 billion euros in a Bloomberg News survey. Twelve-month loans for 442 billion euros expire today.

‘Significant Drain’

“It’s quite a significant drain” of the liquidity taken from the ECB, said Mark Schofield, head of interest-rate strategy at Citigroup Inc. in London. “It’s going to put a bit of upward pressure on the short end of the curve.”

Spain sold five-year notes at an average yield of 3.657 percent, compared with 3.532 percent at a May 6 auction. Demand was 1.7 times the amount sold, below the bid-to-cover ratio of 2.35 at the May sale.

“Deteriorating” growth prospects and challenges in meeting fiscal targets mean Spain’s Aaa classification may be lowered by as much as two grades, Moody’s analysts including Senior Vice President Kristin Lindow said yesterday.

Spain’s five-year note yield rose two basis points to 3.81 percent today.

France’s bonds advanced after the nation sold 7.5 billion euros of debt due in 2018, 2020 and 2026. The 10-year securities were sold at a record low yield of 3.04 percent. The bond drew bids for 3.5 times the amount on offer.

The yield on France’s 10-year security fell five basis points to 3.04 percent. The Italian 10-year yield declined one basis point to 4.09 percent.

Bank Struggle

Bonds of so-called peripheral euro area nations rose as the reduction in appetite for ECB funding damped concern the countries’ banks were struggling to raise funds, fueling demand for assets perceived to be higher risk.

The Greek 10-year yield fell 36 basis points to 10.47 percent, the lowest since June 22 based on closing prices. The Portuguese 10-year bond yield fell 13 basis points to 5.64 percent.

Portugal said today it plans to reopen five to seven bond series through auctions in the third quarter.

The 10-year bund yield rose was little changed at 2.57 percent, having pared a decline after the U.S. Institute for Supply Management’s manufacturing index fell more than economists forecast to 56.2 from 59.7 in May.

The yield premium investors demand to hold 10-year U.S. Treasuries instead of bunds narrowed two basis points to 33 basis points, the least this year.

To contact the reporter on this story: Paul Dobson in London at pdobson2@bloomberg.net

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