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German Notes Drop on ECB Signal Bets; Portuguese Bonds Advance

German two-year notes fell, pushing the yield spread with 10-year bunds to the narrowest in more than two years, amid speculation the European Central Bank will signal further interest-rate increases tomorrow.

Losses today pushed the two-year note yield to the highest in almost three weeks. Portuguese bonds rose, with the two-year yield falling the most in more than five months, as the nation announced a European Union-led rescue loan agreement of as much as 78 billion euros ($116 billion). The ECB is due to announce its latest rate decision tomorrow after tightening by 0.25 percentage point last month, amid signs that the recovery in the stronger economies such as Germany will be sustained.

“We’ve had robust economic data and inflation pushing higher, so the prospect for the ECB to be more hawkish at the next meeting is higher,” said Patrick Jacq, a senior fixed-income strategist at BNP Paribas SA in Paris. “When you have the ECB starting a tightening cycle, you have more pressure at the front end than the long end. The bias for the month ahead remains for more flattening.”

The yield on the two-year note gained five basis points to 1.93 percent at 3:30 p.m. in London, after reaching 1.94 percent, the most since April 11. The 1.5 percent security due March 2013 fell 0.09, or 90 euro cents per 1,000-euro ($1,481) face amount, to 99.225. The 10-year bund yield rose for a third day, climbing one basis point to 3.29 percent.

Yield Spread

The moves left the extra yield investors demand to hold the longer-dated securities at 137 basis points, the least since January 2009, according to closing prices. The 10-year bund yielded five basis points more than similar-maturity U.S. Treasuries. The yield rose above the U.S. equivalent yesterday for the first time since June 2009.

A composite index based on a survey of euro-area purchasing managers in services and manufacturing industries was at 57.8 last month, above the 50 level that marks expansion, London-based Markit Economics said today, matching the median prediction of 14 economists surveyed by Bloomberg News and an initial estimate on April 19. A report yesterday showed European producer-price inflation unexpectedly accelerated to the fastest pace in 2 1/2 years in March.

Euribor futures dropped, sending the implied yield on contracts expiring in December seven basis points higher to 2.18 percent, as investors added to wagers on higher rates from the Frankfurt-based ECB.

Portuguese Agreement, Sale

German government bonds have handed investors a loss of 1.8 percent this year through yesterday, according to indexes compiled by the European Federation of Financial Analysts Societies and Bloomberg, while Treasuries have returned 1.4 percent. Spanish bonds made 2.7 percent while Portuguese debt lost 15 percent.

The yield on the Portuguese two-year note dropped as much as 69 basis points, the most since Dec. 2, to 11.13 percent. Ten-year bonds rose for a fourth day, pushing the yield down 11 basis points to 9.46 percent. The securities yielded 616 basis points more than bunds, from 630 basis points yesterday. The spread reached a euro-era record of 640 basis points on May 29.

Portugal also led a decline in the cost of insuring European sovereign debt. Credit-default swaps on Portugal dropped 29 basis points to 620, according to CMA. An index insuring high-yield corporate bonds fell to the lowest in more than three years.

“The spreads are tightening a bit, so in that sense it’s seen as a slight relief that there’s some agreement,” said Karsten Linowsky, a fixed-income strategist at Credit Suisse Group AG in Zurich. “They still have a lot of challenges.”

Credible Plan

Portugal needs a “credible plan” to bring its deficit under control if it is to regain access to financial markets, Anthony Thomas, a senior sovereign risk analyst at Moody’s Investors Service, said today in an interview in Prague.

Borrowing costs rose at a Portuguese sale of 1.12 billion euros of three-month bills. The securities due in August were issued at an average yield of 4.652 percent, the Treasury said today. That compares with a yield of 4.046 percent at the previous auction of three-month bills on April 20. The auction attracted bids for 1.9 times the amount offered, compared with a bid-to-cover ratio of two last month.

Portugal in April became the third euro-region country to request EU aid after Greece and Ireland. The three-year plan set goals for a budget deficit of 5.9 percent of gross domestic product this year, 4.5 percent in 2012 and 3 percent in 2013, Prime Minister Jose Socrates said in Lisbon.

Spanish 10-year bonds advanced, sending the yield one basis point lower to 5.25 percent, and Irish 10-year yields slid 20 basis points to 10.18 percent.

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