Treasury Two-Year Yields Touch Five-Year Low as Economy Worsens

By Dakin Campbell and Cordell Eddings

Nov. 15 (Bloomberg) -- Treasuries rose for a second straight week, with two-year note yields touching the lowest in five years, as economic growth worsened and Treasury Secretary Henry Paulson changed the terms of the financial-rescue plan.

The yield difference between two- and 10-year notes widened to a five-year high as traders increased bets the Federal Reserve will cut interest rates and focused on short-maturity debt as the Treasury sold the most longer-term securities since 1990. Paulson said the government would no longer buy troubled mortgage assets and would instead focus on relieving pressures in consumer-credit markets.

``There will be a short-term mentality in the Treasury market,'' said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world's largest inter-dealer broker. ``The atmosphere is still risk averse and will probably stay this way until the negative news gets better.''

The two-year note yield fell 12 basis points, or 0.12 percentage point, on the week to 1.22 percent, according to BGCantor Market Data. It touched a five-year low of 1.14 percent on Nov. 13. The 1.5 percent security due in October 2010 rose 7/32, or $2.19 per $1,000 face amount, to 100 17/32. The 10-year note's yield dropped 6 basis points to 3.74 percent. It touched 3.63 percent, the lowest in more than two weeks.

Rates on one-month Treasury bills, viewed as a haven in times of turmoil, fell 4 basis points to 0.05 percent on the week. They touched a record low of 0.04 percent Nov. 13.

Rescue Package

The government sold $55 billion of three-, 10- and 30-year securities at its so-called quarterly refunding during the week to pay for the $700 billion financial-rescue plan and fund a widening budget deficit.

Treasuries will fall over the next six months as the U.S. increases borrowing to bail out its financial system, while government debt in Europe, Asia and Latin America rallies, a monthly survey of Bloomberg users showed.

Paulson said on Nov. 12 that buying ``illiquid'' mortgage- related assets under the rescue plan conceived for that purpose ``is not the most effective'' use of funds. Instead, he proposed shifting the focus to relieving pressures on automobile, credit card, and consumer loans.

The Group of 20 heads of state are meeting in Washington this weekend amid Europe's first recession in 15 years. The region's gross domestic product shrank 0.2 percent last quarter from the previous three months, when it also contracted 0.2 percent, the European Union's statistics office said Nov. 14.

`Flight-to-Quality Bid'

The U.S., Japan, the U.K. and the euro region are headed for their first simultaneous recessions since World War II, according to the International Monetary Fund.

Sales at U.S. retailers dropped 2.8 percent last month, the Commerce Department said yesterday. It was the fourth consecutive drop and the biggest since records began in 1992. Initial claims for unemployment insurance rose last week to the highest level since September 2001, when the economy was last in a recession.

``We are not getting a lot of warm and fuzzy numbers about the economy,'' said David Coard, head of fixed-income trading in New York at Williams Capital Group, a brokerage for institutional investors. ``The weaker-than-expected retail sales number and another equity sell-off are supporting the flight-to- quality bid into the Treasuries.''

U.S. stocks retreated for a second straight week, with the Standard & Poor's 500 Index falling 6.2 percent.

Futures on the Chicago Board of Trade showed an 84 percent chance the Fed will lower its 1 percent target rate for overnight bank lending by 50 basis points at its Dec. 16 meeting. The odds were 64 percent a week ago.

Week's Theme

Two-year notes, more sensitive to monetary policy than longer-maturity securities, outperformed 10-year notes and pushed the gap between the two to 2.62 percent on Nov. 13.

``The essential steepening of the yield curve has been the theme of the week, led by two-year notes,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, one of the 17 primary dealers that trade with the Fed. ``The market is still expecting weak data to continue and more from the Fed in terms of liquidity.''

Yields indicate banks are less willing to make loans to each other even as Paulson said it was ``very important'' for banks to lend. The difference between what they and the Treasury pay to borrow money for three months, the so-called TED spread, widened to 2.10 percentage points, from 2.01 percentage points Nov. 7.

Banks' borrowing costs for dollars rose in the past two days after falling for 23 straight days. The London interbank offered rate for three-month funding increased 9 basis points to 2.24 percent, the British Bankers' Association said.

Uncompleted Transactions

An industry group that advises the Treasury on trading in government debt recommended measures to reduce the record level of uncompleted transactions that have plagued the bond market in the past two months as the credit crunch worsened. The Treasury Market Practices Group urged changes in market practices ranging from financial penalties on failed trades to margining and bilateral cash settlement of failing transactions.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Cordell Eddings in New York at ceddings@bloomberg.net.