By Daniel Kruger Nov. 7 (Bloomberg) -- Treasury two-year note yields touched the lowest since May after the U.S. unemployment rate rose to a 26-year high of 10.2 percent and the Federal Reserve said it will keep rates at record lows for an “extended period.” The difference between yields on 2-year notes and 10-year securities reached 2.70 percentage points, the most since July, before the U.S. sells $81 billion of 3- and 10-year notes and 30- year bonds next week. “You really cannot conceptualize a scenario where the Fed can entertain tightening with over 10 percent on the unemployment rate,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, who oversees $22 billion. The two-year note yield fell five basis points on the week, or 0.05 percentage point, to 0.84 percent, according to BGCantor Market Data. It touched 0.8321 percent yesterday, the lowest level since May 21. The 1 percent security maturing in October 2011 rose 3/32, or 94 cents per $1,000 face amount, to 100 9/32. The 10-year note yield rose 11 basis points to 3.50 percent. Payrolls fell by 190,000 last month, more than forecast by economists, a Labor Department report showed yesterday in Washington. The jobless rate rose from 9.8 percent in September. ‘Lots of Frowns’ “The unemployment rate is what everybody’s going to focus on,” said William O’Donnell, U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, one of 18 primary dealers that trade with the Fed. “That’s ultimately what’s going to resonate in the press and the halls of Congress, where I’m sure there are lots of frowns.” The U.S. economic recovery will probably “run out of gas” as it heads toward a “new normal” of lower long-term growth and higher unemployment than over the previous decade, Nobel laureate Edmund Phelps said. While the economy grew the most in two years in the third quarter and the decline in payrolls may bottom in the first quarter of 2010, that doesn’t change the fact that the economy has lost its “dynamism,” Phelps, a professor at Columbia University in New York, said in an interview with Bloomberg Television. The so-called underemployment rate -- which includes part- time workers who’d prefer a full-time position and people who want work but have given up looking -- reached a record 17.5 percent from 17 percent in September. ‘Slow Grind’ “The job market will have to stabilize and maybe get better before we see the Fed doing anything,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “This is going to be a slow grind in terms of recovery.” The government will sell $40 billion of three-year notes on Nov. 9, $25 billion of 10-year notes Nov. 10, and $16 billion of $30 bonds Nov. 12, all records. President Barack Obama has pushed the nation’s marketable debt to $6.95 trillion. Foreign investors bought $371.9 billion of Treasuries since the start of 2009 through August, according to Treasury data, while Fed custodial holdings of U.S. government debt for foreign central banks have increased 26 percent to $2.15 trillion since the start of the year, according to Fed data. Banks are expected to continue adding to their holdings after increasing their purchases 26 percent to $125 billion in the 12 months through June, Fed data show. ‘Easily Absorbed’ “The market has easily absorbed supply, even though it’s been huge by any standard,” said Christopher Sullivan, who oversees $1.4 billion as chief investment officer at United Nations Federal Credit Union in New York. Two-year note yields declined on Nov. 4 after the Fed reiterated that its target rate will stay near zero for an “extended period.” The central bank said that its commitment to “exceptionally low” rates depends on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.” The difference between rates on 10-year notes and TIPS touched 2.19 percentage points yesterday, the most since Aug. 28, 2008, indicating concern about rising consumer prices was the highest since before the collapse of Lehman Brothers Holdings Inc. Gold futures jumped to a record, topping $1,100 an ounce, on mounting speculation that low U.S. borrowing costs will drive the dollar lower, boosting the appeal of the precious metal as an alternative investment. Increased Issuance Increased issuance of long-term Treasuries and the Fed on hold for the foreseeable future pose risks for investors, said Arthur Bass, a managing director of derivatives in New York at the brokerage Newedge USA LLC. Treasury officials on Nov. 4 announced a long-term target of six to seven years for the average maturity of government debt. The average maturity is currently about 53 months, according to Treasury data, below the historical average of about five years. “The long end of the Treasury market is potentially in trouble,” Bass said. “The dollar has shown some weakness and gold is telling you where people are marching with their feet and putting their assets. All of that portends a steeper yield curve and risk to the long end.” The Australian dollar has gained 25 percent, the euro 12 percent and Canadian dollar 10 percent against the greenback since the beginning of May as the Fed’s commitment to holding borrowing costs near zero has led investors to sell dollars and buy higher yielding currencies. Low rates and Fed purchases of Treasuries and mortgage debt, combined with the Obama administration’s $787 billion fiscal stimulus, helped boost gross domestic product 3.5 percent from July to September. Without the auto industry, which benefited from the government’s “cash for clunkers” program, growth would have been 1.9 percent. U.S. economic growth will slow to 2.4 percent this quarter, according to a Bloomberg survey of banks and securities companies.

Source