The world's most-influential bond market might just be inFrankfurt.

As speculation deepens that the European Central Bank (ECB) willstart quantitative easing just as the Federal Reserve ends its ownbond buying, Europe is gaining more leverage over investorsglobally as the specter of deflation in the region unleashesgreater demand for fixed income. The gravitational pull exerted byGerman bunds may blunt any jump in yields as the Fed moves to raiseU.S. interest rates for the first time since 2006.

None other than Bill Gross, who runs the world's biggest bondfund at Pacific Investment Management Co. (Pimco), said on Aug. 20the direction of 10-year German bunds sets the “tone” forinvestors. A day later, Citigroup Inc. cut its yield forecasts forU.S. Treasuries on weakening growth and inflation expectations inEurope after German yields fell below 1 percent.

“Developments in the euro area are causing long-term ratesto be lower all over,” Amitabh Arora, the New York-based head ofinterest-rate strategy at Citigroup, one of 22 primary dealers thattrade directly with the Fed, said in a telephone interview on Aug.25.

Arora anticipates yields on 10-year Treasuries will end the yearat 2.8 percent, from 2.4 percent as of 9:55 a.m. in New York. Hetrimmed his call from 2.95 percent after the firm's economics teampredicted the ECB will start a 1 trillion-euro (US$1.31 trillion)asset-purchase program by December to keep consumer prices fromfalling as the region's economies sputter.

Bond yields across the euro area, from Germany to France andSpain, have tumbled to records since ECB President Mario Draghisaid at the Kansas City Fed's annual conference in Jackson Hole,Wyoming, on Aug. 22 that the central bank will use “all theavailable instruments needed to ensure price stability” and is“ready to adjust our policy stance further.”

Yields on the German 10-year bund fell to a record 0.866 percenton Aug. 28, while France's benchmark rate reached 1.217 percent.Spain's 10-year bond yields ended yesterday at 2.25 percent—belowthose of comparable U.S. securities.

The growing influence of the ECB also means more investors aretaking cues from the US$1.5 trillion German debt market—rather thanthe $12.2 trillion market for U.S. Treasuries—to find out wherebonds globally are headed.

As 10-year German yields fell below 1 percent last month, forthe first time, similar-maturity securities in the U.S., the U.K.,and Canada were moving more in tandem with bunds than at any timethis year, data compiled by Bloomberg show.

Deflation Risk

On the day the Fed released minutes of its July meeting, Gross,who runs the $223 billion Pimco Total Return Fund, said on Twitterthat 10-year bunds set the “global market tone.”

Worsening economic conditions in Europe may now bolster the casefor more stimulus when the ECB meets on Sept. 4, depressing yieldsfurther. The inflation rate in the 18-nation euro region fell to0.3 percent in August, the lowest in five years, data from theEuropean Union's statistics office showed on Aug 29.

As recently as January 2013, living expenses were rising fasterthan the ECB's target rate of just under 2 percent.

Germany, Europe's largest economy, shrank 0.2 percent in thesecond quarter, while France's stagnated and Italy fell back into arecession, separate reports showed last month.

“The European financial system and economy is a huge portion ofthe developed world,” Guy LeBas, chief fixed-income strategist atJanney Montgomery Scott LLC in Philadelphia, said in a telephoneinterview on Aug. 26. The ECB “is a very powerful central bank thatdrives investment dollars.”

With yields already so low in Europe, speculation that the ECBwill finally embrace a form of monetary stimulus it has longavoided has also been a boon for bonds outside the region.

Debt securities of all types worldwide returned 1.3 percent inAugust, the most since January, according to index data compiled byBank of America Merrill Lynch.

“There's a push for yield, and it's having an effect” on bonddemand around the world, Matthew Eagan, a fund manager at LoomisSayles & Co., which oversees $231 billion, said in a telephoneinterview on Aug. 27.

Rate Alarm

In the U.S., where yields on 10-year Treasuries exceededcomparable bunds by the most since 1999, those on the benchmarknote decreased by the most in seven months in August as investorstook advantage of the yield premium.

The prospect that bond yields will get dragged lower as the ECBmoves to loosen monetary policy is helping drown out some Fedofficials who have pushed for faster U.S. rate increases.

Last month, St. Louis Fed President James Bullard said monetarypolicy may be tightened earlier than officials previouslyexpected.

Philadelphia Fed President Charles Plosser went further, sayingthe central bank should be signaling that rate increases may comesooner and waiting too long to lift borrowing costs riskstriggering inflation and disrupting financial markets.

Traders are pricing in about a 53 percent chance the Fed willboost rates in July, from 63 percent a month ago, according to datacompiled by Bloomberg.

Bond buyers risk overlooking the strength of the U.S. recovery,which will compel the Fed to raise its benchmark rate and prove tobe more important than anything the ECB does, said Wilmer Stith, aBaltimore-based fund manager at Wilmington Trust InvestmentAdvisors, which oversees $14 billion.

The world's largest economy rebounded from its worst dropoff infive years by expanding at a 4.2 percent rate in the secondquarter, government data showed last week.

And while forecasters have repeatedly slashed their yieldforecasts for Treasuries this year, as everything from the harshwinter to uneven labor growth and geopolitical unrest causedinvestors to pile into U.S. debt, they still anticipate 10-yearyields will be at 2.92 percent by Dec. 31.

That's more than a half-percentage point higher than where theynow stand, data compiled by Bloomberg show.

“There's going to be a lot more pulling of teeth in terms ofwhen that first hike takes place,” Stith said by telephone Aug. 26.“But at the end of the day, it's the economy, and that's going tobe the driver” of higher bond yields.

Mark MacQueen, a partner at Sage Advisory Services Ltd., whichoversees $11 billion, says slowdown in the euro region, whoseeconomies are collectively almost 40 percent larger than China's,may hold back U.S. growth and keep Fed Chair Janet Yellen fromsiding with the bank's more hawkish policy makers.

About 40 percent of this year's decline in traders' expectationsfor where yields on five-year Treasuries will be in 2019, whichinfluences the outlook for the 10-year note, has been due toeuro-area concerns, Citigroup estimates.

“If you get deflation in Europe and global growth slows, Yellenwill have trouble finding a good reason to raise rates,” MacQueensaid by telephone Aug. 26 from Austin, Texas.

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