Nov. 12 (Bloomberg) -- Treasuries rose, sending two-year note yields to the lowest since 2003, as stocks plummeted after Treasury Secretary Henry Paulson abandoned plans to buy soured assets from banks in favor of easing consumer credit.

Traders pushed 10-year note yields to the lowest in more than two weeks after Paulson said buying ``illiquid'' mortgage- related assets under a $700 billion plan conceived for that purpose ``is not the most effective'' use of funds. The Federal Reserve urged banks to keep lending. The Treasury's $20 billion auction of 10-year notes drew less demand than forecast.

``This is a flight-to-safety bid again,'' said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. ``The stock market was headed down before Paulson spoke, but he probably made it worse. When you change the rules of the game, it makes people risk averse.''

The two-year note yield fell 9 basis points, or 0.09 percentage point, to 1.16 percent, at 4:53 p.m. in New York, according to BGCantor Market Data. It touched 1.15 percent, the lowest since June 2003. The 1.5 percent security due in October 2010 rose 6/32, or $1.88 per $1,000 face amount, to 100 21/32.

The yield on the benchmark 10-year note decreased 10 basis points to 3.65 percent. It touched 3.63 percent, the lowest since Oct. 27.

Rates on three-month Treasury bills, viewed as a haven in times of turmoil, tumbled 28 basis points to 0.14 percent, the lowest in almost two months.

The Standard & Poor's 500 Index retreated for a third day, plunging 5.2 percent, and the MSCI World Index lost 4 percent.

10-Year Note Sale

The last time two-year note yields dropped beneath today's level was June 25, 2003, the day Fed policy makers under Chairman Alan Greenspan cut the benchmark lending rate to 1 percent, the lowest in a half-century, citing the risk of a ``substantial fall in inflation.''

The government's record sale of 10-year notes drew a yield of 3.783 percent, above the pre-auction trading yield of 3.781 percent. The average forecast of six bond-trading firms surveyed by Bloomberg News was for a 3.769 percent yield. Investors bid for 2.2 times the amount offered, down from 2.31 at the last sale on Oct. 9.

Indirect bidders, a class of investors that includes foreign central banks, were awarded 36 percent of the auction, compared with an average of 26 percent in the previous 10 sales. Investors bid for 2.2 times the amount offered, down from 2.31 at the last auction.

The Treasury earlier drew a rate of 0.07 percent at its sale of $34 billion in four-week bills, the lowest level in the securities' history.

Market Practices Group

``There is a continued appetite for Treasuries as the investment landscape is still tenuous and fragile,'' said Kevin Flanagan, a fixed-income strategist at Morgan Stanley Global Wealth Management Group in Purchase, New York. ``This just underscores the continued mindset that the preference is to hold on to safer securities.''

An industry group that advises the Treasury on trading in U.S. government securities recommended measures to reduce the record level of uncompleted transactions that have plagued the bond market in the past two months as the credit crunch worsened.

The Treasury Market Practices Group urged changes in market practices ranging from financial penalties on failed trades to margining and bilateral cash settlement of failing transactions in Treasuries, according to a statement today.

Dividend Warning

Paulson said he will shelve plans to buy hard-to-trade assets from financial firms under the Troubled Asset Relief Program and focus on relieving pressures on consumer credit.

``Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role,'' Paulson said.

The Fed and other U.S. regulators told banks to keep lending to ``creditworthy'' borrowers and warned against dividend levels that would cut funds available for loans.

``We're all looking for negative growth; the market expects inflation to abate,'' said John Spinello, chief technical strategist in New York at Jefferies Group Inc.

Because their fixed returns are eroded by rising consumer prices, bonds benefit from falling inflation.

The difference between two- and 10-year note yields could widen to 3 percentage points ``over the long term,'' Spinello said. It touched a five-year high of 2.50 percentage points on Nov. 10 as two-year notes, the most sensitive to expectations about monetary policy, led gains. The yield gap narrowed to 2.49 percentage points today. Traders can bet on a widening yield gap by buying two-year notes and selling 10-year notes.

More Bullish

Treasury investors were more bullish this week, a weekly survey of clients by JP Morgan Securities showed. The net percentage of investors betting on rising prices climbed to 27 percent, from 23 percent last week. The figure is the difference between the percentage of investors holding long positions, or bets on higher prices, and those taking short positions, bets on falling prices. The majority of respondents expected no change.

Yields indicate banks are less willing to lend to each other. The difference between what they and the Treasury pay to borrow money for three months, the so-called TED spread, widened to 1.99 percentage points, from 1.75 percentage points yesterday. The gap expanded to 4.64 percent on Oct. 10, the most since Bloomberg began compiling the data in 1984.

To contact the reporters on this story: Cordell Eddings in New York at ceddings@bloomberg.net; Sandra Hernandez in New York at shernandez4@bloomberg.net.

Last Updated: November 12, 2008 16:57 EST