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German Two-Year Notes Drop as Mersch Signals ECB Rate Increase

German two-year notes fell after European Central Bank council member Yves Mersch signaled a readiness to raise interest rates to contain inflation.

The nation’s 10-year bonds rose for a second day as violence intensified in Libya, boosting demand for the safest assets as stocks declined. Two-year notes also declined after a report showed improving German consumer confidence. Treasuries advanced, while Greek government bonds fell.

“The front end’s sold off quite aggressively” since the Mersch story, said Eric Wand, a rates strategist at Lloyds Bank Corporate Markets in London, referring to shorter-dated securities. “The back-end is rallying as a function of broader risk issues.”

The two-year note yield jumped five basis points to 1.43 percent at 4:33 p.m. in London after climbing to 1.46 percent, the most since Feb. 9 and within seven basis points of a more-than one-year high. The 1 percent security due December 2012 fell 0.085, or 85 euro cents per 1,000 euro ($1,369) face amount, to 99.24.

The 10-year yield slid three basis points to 3.15 percent after reaching 3.13 percent, the least since Jan. 25. The yield has climbed 60 basis points since Dec. 31. The difference in yield, or spread, between two- and 10-year securities narrowed nine basis points to 171 basis points, the smallest gap since Nov. 24.

Inflation Risks

“I would not be surprised at most colleagues concluding that we have upside risks to price stability,” Mersch said in an interview in Luxembourg yesterday. With the economy strengthening and inflation in breach of the ECB’s 2 percent limit, policy makers will “inevitably” have to “rebalance our monetary policy stance,” Mersch said, without giving a timeframe.

Three-month Euribor futures fell after Mersch’s comments were published, with the implied yield on the contract expiring in December rising eight basis points to 1.98 percent, as traders added to bets that the ECB will boost borrowing costs. The yield was 1.33 percent at the end of 2010.

Euro-region inflation breached the European Central Bank’s 2 percent ceiling again in January, accelerating to 2.4 percent, the fastest since October 2008.

“Inflation is likely to stay above the 2 percent target for some time which will lead to discussions in the ECB about how they will position their interest rate policy,” said Karsten Linowsky, a strategist at Credit Suisse Group AG in Zurich. He said if inflation accelerates more over the next few months, bunds could fall.

Flight to Safety

Germany’s consumer sentiment index will increase to 6 in March, the highest level in 3 1/2 years, from a revised 5.8 in February, research group GfK AG said today. Italian consumer confidence climbed to 106.4, more than economists forecast, from 105.9 in January, national statistics office Istat said in Rome.

Ten-year U.S. Treasury yields fell as much as 10 basis points as Libya, holder of Africa’s largest oil reserves, erupted into violence after a crackdown on anti-government demonstrators left hundreds dead. It’s the latest nation to be rocked by protests ignited by last month’s ouster of Tunisia’s president and fanned by the Feb. 11 fall of Egyptian President Hosni Mubarak. Unrest has spread to Bahrain, Iran and Yemen.

Libyan leader Muammar Qaddafi said he’s leader of a revolution that requires “sacrifice until the end of life. Muammar al-Qaddafi has no title to be sad about it and resign,” he said in an address aired on state television today. He said rebels had been “drugged” and the “masterminds” behind the uprising are abroad.

Stark Inflation Warning

European stocks declined for a third day, with the Stoxx Europe 600 Index tumbling as much as 1.1 percent before trading 0.5 percent lower.

ECB Executive Board member Juergen Stark said yesterday the ECB will raise rates if necessary to keep inflation in check.

The central bank may raise its key rate by a quarter-point in September, from 1 percent today, according to euro overnight index average, or Eonia, forward contracts. The yield on the contract expiring on Sept. 14 was 1.29 percent as of 8:12 a.m., before Mersch’s comments were published.

The difference in yield, or spread, investors demand to hold German two-year notes instead of similar-maturity U.S. Treasury notes rose to 73.2 basis points today as traders increased bets the ECB will increase interest rates before the Federal Reserve. That’s the most since Feb. 2, when the spread reached 90.8 basis points, the most since January 2009.

Bond Returns

German government bonds lost investors 1.4 percent this year, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. U.S. Treasuries have lost 0.9 percent with U.K. gilts falling 1.9 percent in the period, the indexes show.

The losses compare with gains made in 2010 as the euro-region’s sovereign debt crisis fueled investor demand for the safest fixed-income assets. German bunds returned 6.3 percent in 2010, the indexes show. Treasuries gained 6 percent, while U.K. gilts returned investors 7.6 percent last year.

Irish 10-year yields fell two basis points to 9.12 percent, while similar-maturity Greek yields were five basis points higher at 11.77 percent. Spanish two-year notes declined as the nation auctioned bills, with demand for the six-month securities rising from a January sale. The yield was four basis points higher at 3.20 percent after rising as high as 3.22 percent. The government auctioned 2.87 billion euros of debt, falling short of the maximum target of 3.5 billion euros.

The three-month bills were sold at an average yield of 1.101 percent, compared with 0.98 percent at the last auction on Jan. 25, the Bank of Spain in Madrid said. It sold 1.01 billion euros of six-month debt at an average yield of 1.588 percent, compared with 1.801 percent in January.

Germany plans to auction as much as 7 billion euros in new two-year notes tomorrow, while Italy plans to sell 2.5 billion euros of zero coupon securities due December 2012.

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