By Lukanyo Mnyanda Oct. 7 (Bloomberg) -- European government bonds fell after Australia's central bank slashed interest rates by the most since 1992, prompting speculation other banks may follow suit to avert a worldwide recession. The decline drove the yield on the two-year German note up from the lowest level since March amid speculation coordinated central-bank action after the Reserve Bank of Australia's 1 percentage-point cut in its benchmark rate today will sap demand for the safest assets. The TED spread, a gauge of cash scarcity among banks, dropped from a record and the cost of insuring company bonds against default fell. ``Coordinated moves by central banks to restore financial stability are looking increasingly likely and the market is taking a pause,'' said Nick Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets. ``Underlying sentiment remains nervous.'' The yield on the two-year note rose 10 basis points to 3.16 percent by 4:10 p.m. in London. The 4 percent note due September 2010 dropped 0.19, or 1.9 euros per 1,000-euro ($1,367) face amount, to 101.54. The yield on the 10-year bund, Europe's benchmark government security, rose 1 basis point to 3.76 percent. Yields move inversely to bond prices. The likelihood the world's largest economies are on the brink of a recession is pushing central banks toward cuts in borrowing costs to revive growth. Australia's reduction was its biggest since a recession in 1992. The Federal Reserve may lower its target rate for overnight bank loans by three-quarters of a percentage point at its Oct. 29 meeting, interest-rate futures show. European Central Bank President Jean-Claude Trichet said last week policy makers considered a rate cut. Commercial Paper Government notes extended losses after the Federal Reserve Board, invoking emergency powers, said today it will create a special fund to buy U.S. commercial paper after the credit crunch threatened to cut off a key source of funding for companies. Yields on top-rated overnight U.S. commercial paper dropped 0.74 percentage point to 2.94 percent, according to data compiled by Bloomberg. Investors should favor Europe's shorter-dated government notes because the ECB is likely to cut rates before year-end, Stamenkovic said. The ECB kept the main refinancing rate at 4.25 percent on Oct. 2. Bonds also fell as Europe's Dow Jones Stoxx 50 Index rose 1.2 percent, after earlier tumbling as much as 1.2 percent. The Standard & Poor's 500 Index fell 0.5 percent. Mistrustful Banks The TED spread, or the difference between what banks and the Treasury pay to borrow money for three months, was at 344 basis points today, from 382 percentage points yesterday. It was at a record 391 basis points earlier. There ``has been a reduction in inflation risks,'' ECB council member Vitor Constancio said in a speech in Lisbon. Fellow policy maker Michael Bonello said the day before the bank plans a ``prudent approach'' when weighing the need for rate cuts as the credit crisis clouds the outlook for the economy. ``We will be assessing the information as it comes in and take a decision at the next meeting after due deliberation,'' Bonello, who heads Malta's central bank, said in an interview in Valletta. ``Particularly in these uncertain times, that is the most prudent approach to take.'' Policy makers will probably cut by at least a quarter point next month, according to a Credit Suisse Group index of derivatives. The implied yield on the December Euribor futures contract dropped 6 basis points to 4.47 percent today, the lowest level since May, in a further sign traders expect borrowing costs to fall. Underperform Treasuries The yield advantage of the two-year German government note over equivalent-maturity U.S. securities widened 4 basis points to 167 points. The spread was 226 basis points on June 6, which was the most this year. European bonds handed investors a 2 percent return in the past month as speculation mounted that policy makers will cut borrowing costs to revive the economy, a Merrill Lynch & Co index shows. Treasuries returned 2.3 percent in the same period, according to a separate Merrill index. European bonds stayed lower after the Economy Ministry in Berlin said German factory orders rose for the first time in nine months in August, ending their longest-ever losing streak. The 3.6 percent jump in orders from July, adjusted for seasonal swings and inflation, was ``just a technical payback for eight months of decline,'' said Stefan Bielmeier, an economist at Deutsche Bank AG in Frankfurt, who expects Germany's economy to shrink 0.2 percent next year. Declines by government bonds were limited as money-market rates surged after U.K. lenders held talks with the government on emergency funding and Iceland nationalized its second-biggest bank amid the unprecedented credit squeeze. To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net

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