By Kim-Mai Cutler and Agnes Lovasz Oct. 31 (Bloomberg) -- European two-year government notes headed for the biggest monthly advance since at least 1990 amid speculation the region's central bank will lower interest rates next week to head off a recession in the 15-nation economy. The gains pushed the difference in yield between two- and 10-year bonds to the widest in almost four years as shorter-dated notes, more sensitive to the outlook for rates, outperformed. European Central Bank policy maker Guy Quaden told L'Echo in an interview published today that a further drop in borrowing costs ``is possible'' in the region. ``The market's come a long way, but there's a lot more to go,'' said Nick Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets. ``The market has significantly shifted its views on the ECB. The rapidly deteriorating economic outlook points to significant rate cuts and the continued weak performance of risky assets is giving support to bunds.'' The yield on the two-year German note fell 24 basis points this week to 2.42 percent by 11 a.m. in London, the lowest level since October 2005. The yield slid 1 percentage point, for its fourth monthly loss. The 4 percent bond due September 2010 rose 0.10, or 1 euro per 1,000-euro ($1,276) face amount, to 102.82. The yield on the 10-year bund was little changed at 3.77 percent, leaving it 24 basis points lower since Sept. 30. Yields move inversely to bond prices. Demand for Safety The two-year note, which hasn't risen for four consecutive months since March 2004, surged as concern the credit-market meltdown will push the global economy into a recession sapped demand for higher-yielding assets. Equities around the world slumped, pushing the MSCI World Index of stocks to its worst four-week loss on record. The spread between two- and 10-year yields widened to 136 basis points, the most since December 2004, steepening the so- called yield curve, a chart of bonds of different maturities. Ten-year German bunds yielded less than comparable U.S. Treasuries for the first time this week since November 2007. Ten- year U.S. Treasury notes yield 12 basis point more than bunds. Bonds also gained after a government report showed consumer- price growth in the region slowed this month. The inflation rate fell to 3.2 percent, from 3.6 percent in September, the European Union's statistics office in Luxembourg said today. That matched the median estimate of 27 economists surveyed by Bloomberg. Retail sales in Germany, Europe's largest economy, fell more than economists expected in September. Sales dropped 2.3 percent from August, when they rose 1.9 percent, the Federal Statistics Office said today. Economists forecast a decrease of 1 percent, the median of 15 estimates in a Bloomberg survey showed. Inflation in the euro area was last below 3 percent a year ago and has been above the ECB's 2 percent ceiling in every month since September 2007. Rate Cuts The ECB participated in a coordinated interest-rate reduction by global central banks on Oct. 8 to prevent the collapse of the global financial system, reducing its benchmark rate by half a point to 3.75 percent. The Bank of Japan today lowered its main rate to 0.3 percent to spur growth. Policy makers meet Nov. 6, when they will probably cut the region's main refinancing rate a half point to 3.25 percent, according to a Bloomberg survey of 26 economists. ``There is little reason for the ECB to proceed timidly in cutting interest rates both from the perspective of inflation and deteriorating economic prospects,'' said Peter Mueller, a fixed- income strategist in Frankfurt at Commerzbank AG, Germany's second-largest bank by assets. ``That means yields at around 2.5 percent at the short end of the curve are by no means overpriced.'' The implied yield on the three-month Euribor futures contract due in January fell 8 basis points to 3.42 percent, suggesting traders are increasing bets borrowing costs have further to fall. European Spreads Widen The yield spread between bunds and other debt of the same maturity in the region is near the widest since the euro's debut in 1999 as investors sought the most liquid of government bond markets. The gap between bunds and their Italian counterparts widened to 125 basis points today, the most since 1997. The difference with French 10-year debt was 38.5 basis points, the biggest since February 1996. ``The market seems to be punishing those countries that have adopted large-scale rescues for the banking sector,'' Stamenkovic said. ``Italy always seems to be on the firing line as well because of its poor historical record and fiscal deficits.'' European bonds outperformed Treasuries this month, handing investors a 2 percent return, compared with 0.1 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct and Treasury Master indexes. To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

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