By Matthew Brown and Theresa Barraclough Jan. 4 (Bloomberg) -- Treasury 10-year note yields approached the highest level since June before a report that economists say will show manufacturing expanded last month, adding to evidence the U.S. recovery is gaining momentum. Ten-year yields rose as much as seven basis points to 3.9 percent following the worst year since at least 1978. 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 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 3 basis points, or 0.03 percentage point, to 3.86 percent as of 7:41 a.m. in New York, according to BGCantor Market Data. The 3.375 percent security due November 2019 dropped 7/32, or $2.19 per $1,000 face amount, to 96 1/16. Yields reached 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. ‘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. 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. Pimco Reduces Holdings “Hawkish comments from Fed members Bernanke and Kohn stressing that monetary policy should be pre-emptive to keep a lid on inflation expectations have added to negative bond market sentiment,” strategists from Edinburgh-based RIA Capital Markets Ltd. wrote in a research report today. 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 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.” Jobless Claims 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, from a record 2.88 percentage points on Dec. 22. 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. ISM Index The Institute for Supply Management’s manufacturing index due today climbed to 54.1 in December from 53.6 in November, according to a separate Bloomberg survey. 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 Fed 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. 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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