London, Nov. 17 (Bloomberg) -- European bonds suffered their worst one-day drop in more than a month, led by a decline in U.S. Treasuries, after the Federal Reserve raised borrowing costs and warned the economy was growing faster than its potential.
Bonds extended those losses after a report showed higher prices in the world's largest economy, fanning concern yesterday's increase could soon be followed by others.Today's U.S. inflation numbers show there are "no clear signs that the warnings of the Fed are overdone," said Peter Mueller, an analyst at Commerzbank in Frankfurt. "A tendency to the downside dominates" bond trading, he said.
The yield on the 10-year German bond, Europe's benchmark, rose 11 basis points to 4.96 percent, the largest one-day gain in yields since Oct. 14. Two-year yields rose 11 basis points to 3.84 percent. The December bund futures contract fell 0.88 to 107.33. Yesterday, European bonds yields struck their lowest level since Aug. 30.
The U.S. central bank raised its benchmark interest rate by 25 basis points to 5.5 percent yesterday, returning the benchmark rate to the level it held from March 1997 until September 1998. The Fed also said inflation pressures might warrant further rate increases.
Today a report showed the U.S. inflation rate in the 12 months through October held at 2.6 percent, matching the 2 1/2-year high reached a month ago.
The 30-year U.S. Treasury yield, the bellwether for bonds around the world, rose to its highest level in two weeks at 6.12 percent.
Lower Treasury prices brought down those of European bonds, said Carlo Taticchi, a bond fund manager at Banco di Sardegna in Milan. Still, "the outlook for bonds is more stable. We are looking for 10-year bunds to stay at about 5 percent or slightly better." He favors a portfolio of European and U.S. bonds weighted towards those with longer maturities.
Investors demand an annualized 113 basis points more yield to buy 10-year U.S. Treasuries rather than equivalent European bonds, close to the widest gap since Sept. 1, though down 6 basis points today as investors sold Treasuries. On Oct. 15, that yield difference was as small as just 76 basis points, its narrowest this year.
U.S. bonds have been one of the worst performing government bond markets in the world so far this year, handing investors a loss of 1.13 percent. European bonds, meantime, have been among the best performers, giving investors a return of 0.32 percent in local currency terms.
This week, governments in the 11-nation euro region are expected to sell a total of more than 10 billion euros ($10.4 billion) of debt this week, up from about 1 billion last week. The sales are sapping demand for existing debt and helping to push up yields, analysts said.
"We've also got the new supply in from Germany which is weighing on the market," said Adrian Davies, senior bond strategist at ABN Amro.
Germany's Bundesbank sold 4 billion euros ($4.2 billion) of five-year notes today.l The Bundesbank also said it will sell a new 6 billion-euro batch of the government's 10-year 5.375 percent bond on Nov. 24. The central bank will call for bids on the bonds on Nov. 23.
The French Treasury will sell two- and five-year notes Thursday, while Ireland's National Treasury Management Agency said it plans to sell 10-year bonds at a regular monthly auction also on Thursday.
On Monday, the Italian Treasury sold a total of 2.5 billion euros ($2.6 billion) in three-, five-, and 30-year bonds.
Concerns about rising business confidence--a leading indicator of high street inflation--are "making it a bit harder for this supply to be absorbed," said Phyllis Reed, European bond strategist at Barclays Capital."
Yields on 10-year German bonds have dropped 50 basis points since Oct. 20 on growing confidence that inflation in Europe won't accelerate and diminish the value of fixed-income investments.
A 50 basis-point increase in the European benchmark interest rate from the European Central Bank on Nov. 4 helped reinforce that view. The benchmark rate is now 3 percent.
Still, ECB Chief Economist Otmar Issing warned inflation in the euro region may accelerate because the recent "strong increase in oil prices" isn't yet fully included in the consumer price index.
ECB members meet again tomorrow, and are widely expected to leave interest rates on hold. The bank said in its November report that the rate increase--which took the benchmark rate up from its lowest ever--should keep inflation below the central bank's 2 percent ceiling in coming months.
Euribor interest-rate futures expiring in June currently anticipate three-month interest rates of 3.76 percent. That's far enough above current three-month rates of 3.45 percent to show some investors expect central bank rates will rise in the first half of next year.