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Europe Bonds Rise on Inflation Drop; Spain Yields Fall Below 4%

European government bonds rose, led by shorter-maturity notes, after a report showing euro-area inflation fell to a four-year low boosted speculation the central bank will lower interest rates.

Spanish 10-year yields dropped below 4 percent for the first time since May, while benchmark German yields fell to the lowest level since August as separate data showed the unemployment rate in the region climbed to a record in September. Italian, French and Dutch bonds also rallied before European Central Bank policy makers led by President Mario Draghi meet next week. UBS AG said it expects the ECB will cut borrowing costs at the gathering.

“The data will fuel expectation that Draghi will adopt a dovish tone in the next meeting,” said Lyn Graham-Taylor, a fixed-income strategist at Rabobank International in London. “We are likely to see bids for government bonds, particularly at the shorter end. Having said that, we see this as a trough rather than the beginning of a pathway to deflation.”

Spain’s two-year rate fell eight basis points, or 0.08 percentage point, to 1.52 percent at 4:13 p.m. London time. The 3.75 percent note maturing in October 2015 rose 0.155, or 1.55 euros per 1,000-euro face amount ($1,361) to 104.32. The nation’s 10-year yield was two basis points lower at 4.04 percent after sliding to 3.98 percent, the least since May 3.

The extra yield investors demand to hold Spanish 10-year bonds instead of two-year notes widened six basis points to 251 basis points. The spread, known as the yield curve, shrank to 240 basis points yesterday, the narrowest since June 20.

‘Subdued Outlook’

The euro area’s annual inflation rate fell to 0.7 percent, the least since November 2009, from 1.1 percent in September, the European Union’s statistics office said. The median forecast in a Bloomberg News survey of economists was for it to stay at 1.1 percent.

The ECB has said there is a “subdued outlook” for price growth in the 17-nation euro region and the October data marks the ninth consecutive month that the rate has been less than its 2 percent ceiling. While the economy has exited a recession and surveys have improved, the central bank predicts only a “gradual” recovery.

Today’s labor-market report showed that the jobless rate in August was revised to 12.2 percent from 12 percent previously. The jobless rate among those aged under 25 was 24.1 percent in September.

The ECB will cut its benchmark interest rate by 25 basis points to 0.25 percent at its Nov. 7 meeting, London-based UBS economist Reinhard Cluse wrote in a research note today. The bank previously said policy makers will keep rates on hold until the end of 2015.

Rate Forecasts

BNP Paribas SA, JPMorgan Chase & Co. and Scotiabank all changed their ECB calls today and now predict that officials will cut the benchmark rate in December.

Weaker-than-estimated inflation figures earlier raise “very big” questions about the outlook for inflation and about the ECB’s response, JPMorgan economist Greg Fuzesi wrote in a research note.

Germany’s two-year note yield fell three basis points to 0.12 percent after sliding to 0.11 percent, the lowest since Aug. 1. The 10-year yield was little changed at 1.68 percent after touching 1.65 percent, the least since Aug. 8.

“Bunds are reacting positively to the data,” said Peter Schaffrik, head of European rates strategy at RBC Capital Markets in London. “It’s likely to cement a view that the European Central Bank will not be in a hurry to raise rates. But equally, I don’t expect them to cut rates because of that either.”

Demand Cools

Historically low bond yields damped demand from some German investors. Fourteen percent of institutional investors surveyed in Germany, who together manage more than 300 billion euros, said they want to avoid sovereign debt and focus more on alternative assets because of the low interest-rate environment, according to a survey published today by Universal Investment GmbH in Frankfurt.

Germany’s 10-year break-even rate shrank by five basis points to 1.58 percentage points, the least since July 30, based on closing prices. The rate, a gauge of inflation expectations that is derived from the yield difference between bunds and index-linked securities, has averaged 1.7 percentage points this year.

Volatility on Greek bonds was the highest in euro-area markets today, followed by those of Germany and Italy, according to measures of 10-year debt, the yield spread between two- and 10-year securities and credit-default swaps.

Greek 10-year yields fell as much as 36 basis points to 8.05 percent, the lowest since June 2010.

Spain’s bonds returned 11 percent this year through yesterday, according to Bloomberg World Bond Indexes. Italy’s gained 6.2 percent, while German bonds lost 1.1 percent.

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