By Susanne Walker Jan. 4 (Bloomberg) -- Yields on Treasury 10-year notes were near the highest level since June after a report showing manufacturing expanded more-than-forecast last month added to evidence the U.S. recovery is gaining momentum. The Institute for Supply Management’s factory index rose to 55.9, the highest level in more than three years, from November’s 53.6, according to the Tempe, Arizona-based group. Federal Reserve Vice Chairman Donald Kohn said yesterday that selling assets is among the options being considered by the central bank to pull back record levels of monetary stimulus. “The economic information is warranting the kind of rate move we’ve had,” said John Spinello, chief technical strategist in New York at Jefferies Group Inc., one of 18 primary dealers that trade with the central bank. “We won’t get a significant rally unless the information turns around on the economy, which is not very likely. It won’t change the Fed policy action.” The yield on the benchmark 10-year note was little changed at 3.83 percent at 10:04 a.m. in New York, according to BGCantor Market Data. The 3.375 percent security due November 2019 was steady at 96 8/32. Yields climbed as high as 3.9 percent today. Yields reached 3.91 percent on Dec. 31, the highest level since June 11. Two-year notes rose for the first time since Dec. 17. 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. ‘Active Discussion’ 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. “The appropriate use and sequencing of these tools is under active discussion by the FOMC,” Kohn told the American Economic Association’s annual meeting in Atlanta. “We will be able to unwind our actions when and as appropriate.” The Federal Open Market Committee debated asset sales at its November meeting, with some members in favor and others warning that it would cause “sharp increases” in longer-term interest rates, according to minutes of the meeting. A middle route now being studied would allow small amounts of bonds to be unloaded at announced times. Interpreting Policy Makers Fed Chairman Ben S. Bernanke said yesterday that monetary policy works with a lag and should therefore be “forward looking,” suggesting he may raise rates before inflation starts to pick up. “How the rates markets evolve will depend on interpreting the words of policy makers and divining the actions of the political operators,” wrote Chris Ahrens, head of interest-rate strategy in Stamford, Connecticut, at UBS AG, in a note today. “It’s an election year and markets, which have been focused in the front end on the Fed, will become increasingly concerned about supply in the longer dates.” The Treasury plans to sell 10-year inflation-protected notes on Jan. 11 and issue three-year notes on Jan. 12. Ten-year notes will be sold on Jan. 13 and 30-year bonds on Jan. 14. 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. Pimco Reduces Holdings 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 2.75 percentage points today, down from 2.88 percentage points on Dec. 22. “In one corner we have the ‘v-shapers’ and the deficit hawks who see the only path for rates as up,” wrote William O’Donnell, U.S. government bond strategist at primary dealer Royal Bank of Scotland Group Plc in Stamford, Connecticut. There are others “who see lingering headwinds (housing, households) that will make for a tepid recovery and only a slow retrenchment in the unemployment rate. I side with the latter.” 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. 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. To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net. Matthew Brown in London at mbrown42@bloomberg.net;

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