European Bonds Rally as Slowing Inflation Stokes ECB Rate Bets

European government bonds rallied, pushing Germany’s 30-year yields to the lowest since August, as slowing euro-area inflation boosted speculation the European Central Bank will take more measures to stimulate the economy.

Spanish and Italian two-year rates fell to records after a report showed annual euro-area inflation dropped to 0.7 percent in January, missing analyst estimates for a 0.9 percent reading. Germany’s two-year yield fell to the lowest in almost three months as the data added to pressure on the ECB to add stimulus at a policy meeting on Feb. 6. Deutsche Bank AG and Royal Bank of Scotland Group Plc revised their forecasts for the ECB to lower interest rates as soon as next week.

“The ECB did warn us that inflation would be low but I’m pretty much convinced that they didn’t expect it to be as low as it’s gotten to,” Padhraic Garvey, head of developed-market debt strategy at ING Groep NV in Amsterdam, said by phone today. “It puts pressure on the ECB to maintain ultra-dovish policies. It’s bullish for core bonds.”

Germany’s 30-year yields, those most sensitive to rising consumer prices, dropped five basis points, or 0.05 percentage point, to 2.48 percent at 4:14 p.m. London time after sliding to 2.47 percent, the lowest since Aug. 12. The 2.5 percent bund due in July 2044 rose 1.015, or 10.15 euros per 1,000-euro ($1,350) face amount, to 100.43, set for a fourth weekly advance, the longest run since April.

The nation’s two-year rate fell as much as three basis points to 0.062 percent, the lowest since Nov. 7.

Deflation ‘Ogre’

Investors added to bets on slower price increases as the euro-area report followed data yesterday showing stagnant inflation in Germany. That nation’s 10-year break-even rate, a measure of inflation expectations derived from the difference in yields on bunds and index-linked securities, fell two basis point to 1.39 percentage points, the lowest level since May 2012, based on closing market rates.

ECB policy makers, led by President Mario Draghi, lowered the main refinancing rate to a record-low 0.25 percent in November to counter slowing inflation. International Monetary Fund Managing Director Christine Lagarde described deflation as the “ogre that must be fought decisively,” speaking at the National Press Club in Washington on Jan. 15.

“It was a big downside surprise and we’ve seen the reaction in market is quite strong,” said Peter Schaffrik, head of European rates strategy at Royal Bank of Canada in London, referring to today’s inflation data. “The key thing now is how the European Central Bank is going to react.”

Implied Yields

Euribor futures contracts rose as traders added to bets that interbank borrowing costs would fall. The implied yield on Euribor contracts expiring in December 2014, a measure of the outlook for three-month interbank lending rates, dropped three basis points to 0.25 percent after reaching an all-time low for the contract of 0.235 percent.

A crisis in emerging markets has boosted demand for the relative safety of European fixed-income securities this month.

The Argentine peso’s 19 percent devaluation this month led declines in developing nations’ currencies, with Russia’s ruble losing 6.9 percent, the second-biggest drop. The Turkish lira’s slide to a record low on Jan. 27 prompted the central bank to hold an emergency meeting, at which it more than doubled its main interest rate. South African policy makers unexpectedly raised rates as the rand slid to a five-year low.

The Bank of America Merrill Lynch Global Broad Market Index returned 1.4 percent in January as of yesterday, including reinvested interest, the most since December 2011. The gauge, which tracks more than 21,200 securities with a market value exceeding $45 trillion, shows yields are about 1.9 percent on average, down from almost 2.1 percent at the end of December and last year’s high of 2.27 percent in September.

Record Lows

Spain’s two-year yield dropped six basis points to 0.947 percent, the lowest on record. Italy’s two-year rate fell as much as eight basis points to a record 0.921 percent.

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

Finland’s 10-year yield fell as much as eight basis points to 1.76 percent, the lowest since June 17. The rate on similar-maturity Dutch bonds dropped to 1.86 percent, the least since June 7.

German bonds returned 1.7 percent this year through yesterday, headed for their biggest monthly gain since July 2012, Bloomberg World Bond Indexes show. Spain’s earned 2.6 percent and Italy’s gained 1.8 percent.