By Cordell Eddings Nov. 19 (Bloomberg) -- Treasuries two-year yields dropped to the least this year as a lower-than-forecast increase in an index of leading economic indicators supported bets that the Federal Reserve will keep rates near zero for the foreseeable future. Two-year note yields are close to the lowest on record as the Conference Board’s index of U.S. leading indicators rose 0.3 percent in October, below the median forecast for a 0.4 percent increase in a Bloomberg News survey. Federal Reserve Bank of St. Louis President James Bullard yesterday said experience indicates policy makers may not start to increase interest rates until early 2012. “As long as the economy is stuck in a rut and there are not viable fixed-income alternatives, they will buy Treasuries,” said George Goncalves, chief fixed-income rates strategist at Cantor Fitzgerald LP, one of 18 primary dealers that trade directly with the Fed. “Year-end pressures and the need for yield is pushing investors out the curve.” The two-year note yield fell seven basis points to 0.68 percent at 11:23 a.m. in New York, according to BGCantor Market Data. The 1 percent security due October 2011 rose 4/32, or $1.25 cents per $1,000 face amount, to 100 19/32. The yield touched 0.6729, the lowest since Dec. 19. They fell to an all- time low of 0.64 percent on Dec. 17. The U.S. will auction $44 billion of two-year notes on Nov. 23, $42 billion of five-year debt on Nov. 24 and $32 billion of seven-year securities on Nov. 25. The $44 billion in two-year notes matches a record and the five- and seven-year amounts are both record. Don’t Dismiss Bullard will be a voting member of the Federal Open Market Committee next year. “The fact that he introduced the idea should not be dismissed as the ranting of a madman,” according to a report by senior economist Tom Porcelli and interest-rate strategist Christian Cooper at RBC Capital Markets in New York. “Even the most bearish analysts weren’t talking about 2012 as a possibility. But the idea has just received credibility.” RBC is one of the 18 primary dealers that trade with the Fed. Bullard’s comments followed a Nov. 16 speech by Fed Chairman Ben S. Bernanke in which he indicated that the central bank’s extended period of low borrowing costs may be even longer amid economic “headwinds.” The two-year note yield fell 4 basis points that day while the yield on the 10-year security dropped 9 basis points. The Fed repeated its pledge at its Nov. 4 meeting to keep borrowing costs at a record low to support the economic revival. Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said the “systemic risk” of new asset bubbles is rising with the Fed keeping interest rates at record lows. ‘Painful Level’ “The Fed is trying to reflate the U.S. economy,” Gross wrote in his December investment outlook posted on the company’s Web site today. “The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher- risk bonds or stocks.” U.S. marketable debt totaled $6.95 trillion in October, after climbing to a record $7.01 trillion in September. The pace of U.S. economic growth, which was 3.5 percent in the third quarter, will slow to 3 percent in the fourth and to 2.65 percent in the first three months of 2010, according to Bloomberg surveys of banks and securities companies. The Philadelphia Fed’s general economic index, a gauge of manufacturing in the Philadelphia region, rose to 16.7 in November, more than forecast, from 11.5 in October. ‘Lose Confidence’ Futures contracts on the Chicago Board of Trade show just a 9.4 percent chance the Fed will increase its target for overnight bank loans to 0.5 percent by March, down from 32.4 percent a month ago. Policy makers cut the target to a range of zero to 0.25 percent in December. President Barack Obama said yesterday in an interview with Fox News in Beijing that the U.S. must get the federal deficit under control. If the government continues to pile up debt, “people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession,” Obama said. The difference between 2- and 10-year yields widened yesterday after a government report showed the cost of living rose more than forecast in October. The spread was little changed today at 2.63 percentage points, increasing from 2.43 percentage points a month ago. To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net.

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