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European Bonds Surge as ECB Unexpectedly Cuts Key Interest Rate

Euro-area government bonds surged, led by Italian and Spanish securities, after the European Central Bank unexpectedly cut its benchmark interest rate to a record low, boosting demand for fixed-income assets.

Italy’s two-year yield fell to the lowest level in more than five months, while the rate on Germany’s two-year notes dropped to the least since May. The ECB reduced the main refinancing rate by 25 basis points to 0.25 percent. The decision was forecast by three out of 70 economists in Bloomberg News survey, with the remainder predicting no change. ECB President Mario Draghi, speaking to reporters in Frankfurt, said weaker growth is a downside risk to inflation.

“The euro region is likely to get stuck in a low-growth, low-inflation environment for a while,” said Harvinder Sian, a fixed-income strategist at Royal Bank of Scotland Group Plc in London. “For the ECB’s easing bias to have any meaningful credibility at all, it has to act. And it did.”

Italy’s 10-year yield slid 12 basis points, or 0.12 percentage point, to 4.09 percent at 4:31 p.m. London time after reaching 4.04 percent, the least since May 28. The 4.5 percent bond maturing in March 2024 rose 1.025, or 10.25 euros per 1,000-euro ($1,339) face amount, to 103.785. Italian two-year yields fell as much as 18 basis points to 1.24 percent, the lowest level since May 20.

Spain’s 10-year yield fell 10 basis points to 4.05 percent, the biggest decline since Oct. 1. The rate on the nation’s two-year notes dropped 11 basis points to 1.42 percent.

Inflation Slows

Data released on Oct. 31 showed the annual inflation rate in the 17-nation currency bloc fell to 0.7 percent, the lowest since November 2009.

The ECB now has just one more quarter-point cut left before reaching zero, increasing the likelihood of unconventional tools such as quantitative easing or a negative deposit rate if prices slow further or the economic recovery stalls. Euro-area inflation is less than half the ECB’s 2 percent target and unemployment is at the highest level since the currency bloc was formed in 1999.

The ECB kept its deposit rate at zero and trimmed the marginal lending rate to 0.75 percent.

Pledging to keep borrowing costs low for an “extended period,” Draghi said weakening price pressures justified the ECB’s surprise decision to cut its main interest rate.

“We may experience a prolonged period of low inflation,” Draghi told reporters after the central-bank decision.

Spread Tightening

The additional yield, or spread, investors demand for holding Italian 10-year bonds compared to their German equivalents narrowed seven basis points to 240 basis points after dropping to 236, the least since Oct. 24. Spain (GSPG10YR)’s 10-year yield spread over Germany tightened four basis points to 237 basis points.

“The strong gain in peripheral bonds today reflects a market theme that looser policy and more liquidity will benefit countries like Italy and Spain more than core countries like Germany,” said Lyn Graham-Taylor, a fixed-income strategist at Rabobank International in London. “We expect the yield spread tightening trend to continue.”

Spain sold 1.14 billion euros of 10-year securities today at the lowest auction yield in more than three years. The Madrid-based Treasury allotted the 2023 bonds at an average yield of 4.164 percent, compared with 4.269 percent at a previous sale on Oct. 3. Investors bid for 2.57 times the amount of debt on offer versus 1.96 times in October.

Unlimited Cash

Draghi said that the central bank will extend its unlimited offerings of one-month and three-month cash until the middle of 2015.

“We continue to monitor closely money market conditions and their potential impact on our monetary policy stance,” Draghi said. “We are ready to consider all available instruments.”

Germany’s 10-year yield fell five basis points to 1.69 percent. The two-year rate dropped five basis points to 0.09 percent after declining to 0.05 percent, the least since May 31.

The German 10-year break-even rate dropped four basis points to 1.52 percentage points, the lowest since June 25, based on closing prices. The rate, a gauge of inflation expectations, is derived from the yield difference between bunds and index-linked securities.

Five-year inflation swap rates, a market gauge of price-growth expectations over that period, declined to 1.34 percent on Nov. 1. That’s within one basis point of the level reached in June last year, which was the lowest since December 2008. The rate slid two basis points to 1.37 percent today.

The implied yield on Euribor contracts expiring in December 2014, a measure of the outlook for three-month money-market rates, fell seven basis points to 0.34 percent, after dropping to 0.27 percent.

Italian securities gained 6.4 percent this year through yesterday, according to Bloomberg World Bond Indexes. Spain’s returned 11 percent, while Germany’s lost 1.3 percent.

To contact the reporters on this story: Neal Armstrong in London at narmstrong8@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net

To contact the editor responsible for this story: Paul Dobson at pdobson2@bloomberg.net

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