By Matthew Brown and Theresa Barraclough Jan. 4 (Bloomberg) -- Treasuries fell, following the worst year since at least 1978, before reports this week that economists said will show the U.S. recovery is gaining momentum. Ten-year yields were near the highest level since June on speculation factories expanded and companies cut the fewest workers in two years last month. A Labor Department report last week showed initial jobless claims fell to the lowest level since July 2008. Pacific Investment Management Co., which runs the world’s biggest bond fund, said it is reducing holdings of U.S. and U.K. debt as those nations expand borrowing. “The strength of the recovery is making people nervous,” said Charles Diebel, head of European rate strategy at Nomura International Plc in London. “There are a lot of big reports this week culminating in payrolls, and there has obviously been an improving trend in jobless data over the last few weeks.” The yield on the benchmark 10-year note rose six basis points, or 0.06 percentage point, to 3.90 percent as of 8:15 a.m. in London, according to BGCantor Market Data. The 3.375 percent security due November 2019 dropped 1/2, or $5 per $1,000 face amount, to 95 24/32. Yields were 3.91 percent on Dec. 31, the highest level since June 11. The 10-year yield will climb to 3.97 percent at the end of 2010, according to a weighted forecast of economists surveyed by Bloomberg News. The yield may rise above 4 percent before the end of the week, Diebel said. Treasuries were the worst performing sovereign debt market in 2009 as the U.S. sold $2.1 trillion of notes and bonds to fund efforts to bolster the economy and financial markets. Pimco Outlook Pimco is also turning cautious on corporate bonds and Treasury Inflation Protected Securities, according to Paul McCulley, a portfolio manager and member of the company’s investment committee. The Newport Beach, California-based company is underweight so-called mortgage-backed securities, according to the report. “This all leaves us with portfolios that appear, more than at other times, to be hugging the benchmarks with no bold positioning,” McCulley wrote on the company’s Web site. “We’re making a very active decision to run light on risk.” The spread between two- and 10-year Treasury yields widened to a record last month as investors bet an accelerating recovery will fuel inflation and damp demand for government debt during unprecedented government bond sales. The difference was 2.72 percentage points today, from a record 2.88 percentage points on Dec. 22. Jobless Claims Initial jobless claims fell by 22,000 to 432,000 in the week ended Dec. 26, the lowest level since July 2008, the Labor Department said Dec. 31, pointing to an improvement in the labor market that will help sustain economic growth this year. Payrolls declined by 1,000 in December, after falling 11,000 in November, according to the median estimate of economists in a Bloomberg News Survey before the Jan. 8 report. That would be the smallest reduction since December 2007. The Institute for Supply Management’s manufacturing index due today climbed to 54 in December from 53.6 in November, according to a separate Bloomberg survey. Never have Treasuries underperformed stocks as much as in 2009, and the world’s biggest bond dealers say this year may offer more of the same as the U.S. economy recovers and unemployment abates. Treasuries lost investors 3.72 percent last year, after returning 14 percent in 2008 when credit markets froze. The Standard & Poor’s 500 Index advanced 23.5 percent last year. Primary Dealers Wall Street’s 18 primary dealers, who correctly forecast yields would rise last year as bond prices fell, see borrowing costs increasing again as the Federal Reserve withdraws some of the funding that more than doubled the central bank’s balance sheet to $2.24 trillion in the last two years. Bonds will also lag behind as the Treasury keeps up the pace of record debt sales to finance an unprecedented $1.4 trillion budget deficit. “Treasuries will have a hard time,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc. “There is a tremendous amount of debt for the market to buy with the economy turning around and the Fed starting to pull back.” An investor survey showed fund managers remained bearish on Treasuries through the week ended Dec. 31. Ried Thunberg’s index measuring the outlook for Treasuries through the end of March fell to 42, from 43 the previous week. A figure below 50 shows investors expect prices to fall. The company, based in Jersey City, New Jersey, interviewed 15 fund managers controlling $1.27 trillion. To contact the reporter on this story: Matthew Brown in London at mbrown42@bloomberg.net; Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.

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