By Agnes Lovasz Oct. 15 (Bloomberg) -- European notes advanced after a report showed inflation in the euro area slowed for a second month in September as oil prices fell, giving policy makers scope to reduce interest rates. The gains sent two-year yields down from the highest level in more than a week, with notes also supported as stocks snapped a two-day rally. The inflation rate fell to 3.6 percent from 3.8 percent in August, the European Union statistics office in Luxembourg said today. European Central Bank President Jean- Claude Trichet suggested yesterday slowing inflation may give policy makers latitude to cut rates. ``Headline inflation is now easing quickly and the ECB stance has shifted toward an easing cycle,'' said Ralf Preusser, a London-based fixed-income strategist at Deutsche Bank AG, Germany's largest lender. ``The economy is headed for a technical recession in the third quarter and prospects for recovery in the fourth have been snubbed by the rapid escalation of the credit crunch. We are long two-year rates.'' A long position is a bet an asset price will rise. The yield on the two-year note fell 7 basis points to 3.13 percent by 12:20 p.m. in London, after rising yesterday to 3.27 percent, the highest level since Oct. 3. The price of the 4 percent security due September 2010 increased 0.12, or 1.2 euros per 1,000-euro ($1,361) face amount, to 101.58. The yield on the 10-year German bund, Europe's benchmark government security, which is more sensitive to the inflation outlook, slipped 2 basis points to 4.10 percent. Yields move inversely to bond prices. Concern on Earnings European notes snapped a two-day drop as equities in the region fell for the first time in three days. The MSCI World Index of stocks lost 0.3 percent today, and the Dow Jones Stoxx 600 Index declined 2.6 percent as concern about a possible deterioration in corporate earnings overshadowed a $2 trillion global bank rescue. The threat of recession in the euro region is also underpinning bonds. Germany's leading economic institutes cut their joint growth forecast for next year yesterday, saying the economy ``is on the edge of a recession.'' Germany's economy, Europe's largest, may fail to grow in 2009 after the yearlong credit squeeze pushed up lending costs and global expansion slowed, government adviser Beatrice Weder di Mauro said. ``We projected a slowdown for this year, but this additional dimension with the banking crisis wasn't foreseen,'' Di Mauro, a member of Chancellor Angela Merkel's panel of economic advisers, said in an interview with Bloomberg Television yesterday in Frankfurt. Asked whether the German economy could shrink next year, she said ``I can't rule it out.'' Inflation Euro-region inflation matched the initial estimate of 3.6 percent published Sept. 30. German consumer prices rose 3 percent from a year earlier, matching an initial estimate from Sept. 26, the Federal Statistics Office in Wiesbaden said today. Deutsche Bank predicted the inflation rate will fall below 3 percent in November and to 2 percent by March. The ECB will lower its key rate to 3.25 percent this year and to 2.75 percent by March, from 3.75 percent currently, Deutsche Bank forecast. ``There has been a materialization of the downside risks to growth and we have to take that into consideration in all respects, and particularly as regards the influence that it has on the upside risks for price stability,'' Trichet said yesterday in New York. `Focus on Weak Data' Bond yields ``will fall as a recession in Europe becomes the main story,'' said Peter Mueller, a fixed-income strategist in Frankfurt at Commerzbank AG, Germany's second-biggest lender. ``We are starting to see a move away from the financial crisis towards a focus on the weak data.'' European bonds handed investors a 0.8 percent return since the end of August, while U.S. Treasuries returned 0.3 percent, according to Merrill Lynch & Co.'s EMU Direct Government and Treasury Master indexes. The difference in yield between two- and 10-year securities widened to 96 basis points, the most in more than three years. Shorter-dated notes outperformed their longer-maturity counterparts in anticipation of more ECB interest-rate reductions to avert a global economic slowdown. The ECB participated in a coordinated rate reduction by central banks around the world on Oct. 8, bringing its key rate down half a percentage point. The same day Trichet declined to rule out more cuts. Interest-rate futures show traders have raised bets the ECB will reduce borrowing costs this year, with the implied yield on the December three-month Euribor futures contract falling 7 basis points since the end of last week to 4.7 percent today. To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

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