March 18 (Bloomberg) -- U.S. 10-year Treasury notes posted their biggest weekly gain since December as slower-than-expected inflation spurred traders to scale back bets for how high the Federal Reserve will raise interest rates this year.

Traders drove down yields from last week's peak of 4.8 percent, the highest since before the Fed began raising borrowing costs in June 2004, as they grew less certain the central bank will lift its benchmark rate to 5 percent from 4.5 percent now. Fed policy makers next meet to decide rates on March 27 and 28.

``There certainly was a different tone this week,'' said James Sarni, senior managing partner in Los Angeles at Payden & Rygel, which manages $54 billion, primarily in bonds.

For the week, the yield on the benchmark 10-year note fell almost 8 basis points, or 0.08 percentage point, to 4.67 percent, according to New York-based bond broker Cantor Fitzgerald LP. It was the biggest drop since the week ended Dec. 16. The price of the 4 1/2 percent security maturing in February 2016 rose almost 5/8, or $6.25 per $1,000 face amount, to 98 5/8.

Bond yields, which move inversely to prices, will fall further in mid-year as the economy slows, said Sarni, who expects the Fed to raise the benchmark twice more to 5 percent.

The Labor Department on March 15 said so-called core consumer prices, which exclude food and energy, rose 0.1 percent in February from the month before, below the 0.2 percent median estimate of economists surveyed by Bloomberg.

The report cast doubt that the Fed would raise rates three times this year to 5.25 percent.

`Stopped Being Bearish'

``It's not that the market is bullish; it's that it stopped being bearish,'' said David Ader, an interest-rate strategist at Greenwich, Connecticut-based RBS Greenwich Capital. The firm is one of 22 primary dealers of U.S. government securities that trade with the Fed.

The market may enter a ``dead zone'' where yields are little changed for ``several weeks,'' Ader said.

Two-year notes had their biggest weekly gain since Hurricane Katrina slammed into the Gulf Coast, causing traders to speculate at the time that the damage would cause the Fed to slow the pace of rate increases. The yield on the 4 5/8 percent note due in 2008 fell 10 basis points, the most since a 31 basis-point plunge in the week ended Sept. 2.

Treasuries pared some of their weekly advance yesterday after the Fed said industrial production in the U.S. rebounded last month. The central bank warned of rising production and a stretched labor market in its Jan. 31 policy statement, when it said ``possible increases in resource utilization'' may ``add to inflation pressures.''

5 Percent 'Minimum'

``I don't know anyone that's talking about the Fed not being at 5 percent at a minimum,'' said David Petrosinelli, who manages $4 billion at Shay Assets Management Inc. in Chicago. Petrosinelli said he sold two- and three-year notes this week.

Some of yesterday's drop may have been due to traders preparing for a speech by Fed Chairman Ben S. Bernanke on March 20 to the Economic Club of New York, said Alan De Rose, a trader and Treasury market strategist in New York at CIBC World Markets Inc. Also, the government is scheduled to auction two-and five- year notes next week.

``We've had a huge rally,'' De Rose said. ``It's not unreasonable'' for the market to fall, he said.

The Fed said yesterday that output at factories, mines and utilities gained 0.7 percent last month, compared with a 0.3 percent decline in January. A rise of 0.8 percent was expected, based on the median estimate of 60 economists in a Bloomberg survey. The share of industrial capacity in use rose to 81.2 percent from 80.9 percent.

`Bearish'

``We're a little bearish on the market,'' said Alex Li, an interest-rate strategist in York at Credit Suisse Securities USA LLC, a primary dealer.

Interest-rate futures show traders kept bets the Fed will increase its key rate to 4.75 percent this month. The chance of a 5 percent rate at the meeting in May dropped to 73 percent from 90 percent at the beginning of the week, and traders erased bets on any increase in June, from 22 percent odds March 13.

Next week the government may say the core producer price index, which excludes food and energy, rose 0.1 percent in February from a month earlier, according to the median estimate of economists surveyed by Bloomberg. The index rose 0.4 percent in January, its biggest increase in a year.

TIPS

Yields on Treasury Inflation Protected Securities, or TIPS, which are intended to provide a hedge against rising consumer prices, show investors' inflation expectations dropped over the past two weeks.

The gap in yields between Treasuries and U.S. inflation- linked debt due in 10 years was 2.52 percentage points yesterday, from 2.62 percentage points on March 3. The difference in yield represents the average rate of inflation traders expect over the life of the securities.

Yields on two- and 10-year notes briefly drew even for the first time in more than a week, also a sign that investors are less concerned about inflation, which erodes the purchasing power of fixed-income payments.

The gap was 188 basis points, or 1.88 percentage points, when the Fed began lifting borrowing costs.

The University of Michigan yesterday said its index of consumer confidence held at 86.7 in February. A reading of 88 was expected, according to the median forecast of 52 economists surveyed by Bloomberg.

``The economic picture hasn't changed and it is still one that shows growth will be strong,'' said Hidehiko Maejima, a bond strategist at BNP Paribas Securities Japan Ltd. in Tokyo. ``The data we're seeing don't argue for a sustainable drop in yields.''

To contact the reporters on this story: Daniel Kruger in New York at at Dkruger1@bloomberg.net; Elizabeth Stanton in New York at estanton@bloomberg.net

Last Updated: March 18, 2006 09:14 EST