July 25 (Bloomberg) -- The U.S. will probably pay the most in four years to sell two-year notes after Federal Reserve Chairman Alan Greenspan said ``sustained'' growth will require higher interest rates and on concern Chinese demand may fall.

The yield on the 3 5/8 Treasury maturing in June 2007 has risen 25 basis points, or 0.25 percentage point, since the government sold the securities on June 29. The increase suggests the U.S. may pay about $2.5 million more in annual interest on each $1 billion notes sold.

The Treasury will announce the size of its two-year note auction today at 11 a.m. in Washington. The U.S. will probably sell $20 billion of the securities on July 27, according to the median estimate of analysts surveyed by Bloomberg.

Two-year securities are among the most sensitive to changes in interest rates. Greenspan told a congressional committee on July 20 the economy was on a ``firm footing'' and the Fed will continue to raise interest rates. The next day, the yield on the two-year Treasury reached the highest since August 2001 after China scrapped its decade-old peg to the U.S. currency, which may reduce the country's demand for dollar-denominated assets.

``We don't like shorter-dated Treasuries, and investors are underestimating the potential rise in yields,'' said Vincent Kok, head of international fixed-income at State Street Global Advisors in London, which manages about $1.4 trillion. ``The economy is growing very strongly and there's room for the Fed to move rates up quite a lot more.''

State Street has been selling two-year notes for the past six months, Kok said.

U.S. government debt maturing between one and three years returned 1.1 percent so far this quarter, according to Merrill Lynch & Co. indexes. Euro-region securities with a similar maturity range earned 2 percent and gilts handed investors a 3.1 percent return.

China View

The benchmark two-year note yielded 3.90 percent at 5 p.m. in New York on July 22, according to bond broker Cantor Fitzgerald LP. The price has fallen 15/32, or $4.69 per $1,000 face amount to 99 15/32, since the security was sold last month. Bond yields move inversely to prices.

The last time the Treasury sold two-year notes with a coupon above 3.8 percent was on July 25, 2001, when it issued 3 7/8 percent notes.

``The market is taking the view that China may not be buying so many Treasuries as before,'' said Karsten Linowsky, a fixed- income strategist at Credit Suisse Group in Zurich. Linowsky recommends selling Treasuries and forecasts the two-year note's yield will reach as high as 4.5 percent by year-end.

Largest Foreign Buyer

Chinese investors, including the central bank, bought $78 billion of Treasuries in the year through May, making it the biggest foreign buyer of U.S. government debt, Treasury Department figures show.

China's government accumulated the bonds as authorities defended the yuan's peg to the dollar. The People's Bank of China said it will now value the yuan against currencies including the euro, the yen and the Hong Kong dollar, which may reduce the need to buy the U.S. currency.

China was the second-largest foreign holder of Treasuries with $243 billion at the end of May, according to Treasury Department data. Only Japanese investors, who held about $685 billion of the more than $4 trillion of tradable Treasuries, rank higher.

`Buying Opportunity'

The Treasury may benefit as the yields draw investors who are betting inflation will remain tame this year.

``We see this drift higher in yields as a buying opportunity,'' said Stuart Thomson, a fixed-income strategist at broker Charles Stanley Sutherlands Ltd. in Edinburgh, who recommends buying two-year Treasuries. ``Inflation has fallen in the past year and there is no reason to expect it to reaccelerate.''

Greenspan last week said inflation is ``well-contained.'' Consumer prices were unchanged in June after falling 0.1 percent a month earlier, the Labor Department said on July 14. Excluding food and energy, prices rose 0.1 percent last month. Consumer prices were up 2.5 percent for the 12 months ended in June, compared with a 2.8 percent gain in May.

Fed policy makers have lifted their interest-rate target for overnight lending between banks nine times since June 2004, to 3.25 percent from 1 percent. They next meet on Aug. 9 and will raise the rate to 3.5 percent, according to the median forecast of 31 economists surveyed by Bloomberg.

Raising the Forecast

David Rosenberg, chief North American economist for Merrill Lynch & Co. in New York on July 22 raised his forecast for the year-end federal funds rate to 4 percent from 3.5 percent.

``We must face the reality that more rate hikes are coming,'' Rosenberg wrote in a research note sent to clients. ``There was precious little in the Chairman's sermon even remotely hinting that the Fed is close to being done in its current tightening program.''

``No doubt we will see more upward pressure at the front-end of the Treasury curve,'' he wrote.

The Treasury hasn't sold a two-year note with a coupon as high as 4 percent since May 2001.

The gap between the two-year Treasury note yield and the Fed's target was 69 basis points on July 22, above than the average of 40 basis points in the past decade. A wider difference indicates traders are betting on interest-rate increases.

Date           Issuer         Amount              Maturity
07/25/05       Belgium                            2010
07/25/05       Belgium                            2015
07/26/05       Japan          700 bln yen         2025
07/26/05       U.S.                               2025*
07/26/05       U.K.                               2020*
07/26/05       Australia                          2010
07/27/05       Thailand       2 bln baht          2012
07/27/05       Thailand       2 bln baht          2020
07/27/05       Philippines    4 bln pesos         2030
07/27/05       U.S.                               2007
07/28/05       Japan                              2007
07/28/05       Italy                              2015
07/28/05       Italy                              2012
07/28/05       Italy                              2008


* Inflation-linked.

To contact the reporter on this story: Rodrigo Davies at rdavies13@bloomberg.net

Last Updated: July 24, 2005 19:18 EDT