Oct. 26 (Bloomberg) -- Treasuries fell, with 10-year note yields touching their highest level in two months, as the U.S. began to sell a record $123 billion of notes to fund its stimulus program and record deficits.

Government securities declined for a fourth day as the Treasury sold of $7 billion of five-year Treasury Inflation Protected Securities at a yield of 0.769 percent. The offering, which drew higher-than-average demand, will be followed by three auctions of fixed-rate notes this week.

“We are still at relatively low yield levels, which in front of so much supply and an economy that seems to be starting to turn the corner, don’t seem justified,” said Ajay Rajadhyaksha, head of U.S. fixed-income strategy in New York at Barclays Plc, one of the 18 primary dealers required to bid at Treasury auctions.

The yield on the 10-year note increased eight basis points, or 0.08 percentage point, to 3.57 percent at 4:20 p.m. in New York, according to BGCantor Market Data. The yield touched 3.58 percent, the highest level since Aug. 24. The 3.625 percent security maturing in August 2019 fell 22/32, or $6.88 per $1,000 face amount, to 100 15/32.

“The momentum suggests we could move higher in yields,” said David Ader, head of U.S. government bond strategy in Stamford, Connecticut, at CRT Capital Group LLC. “If we break 3.52 percent, then the next projection is 3.76 percent. Resistance is at 3.28 percent.”

The 10-year yield will increase to 3.56 percent by year- end, according to the average forecast of analysts in a Bloomberg survey, with the most recent estimates given the heaviest weightings.

Five-Year TIPS

The U.S. is scheduled to sell $44 billion of two-year notes tomorrow, $41 billion of five-year notes on Oct. 28 and $31 billion of seven-year securities on Oct. 29.

The auction today is a reopening of the $8 billion five- year TIPS offering on April 23, and the notes mature in April 2014. The securities drew a yield of 1.278 percent at the April sale.

The bid-to-cover ratio, which gauges demand by comparing the amount bid with the amount offered, was 3.10, the highest level since October 1997’s 3.56 percent. For the past five sales of the securities, the ratio averaged 2.31.

Indirect bidders, the category of investors that includes foreign central banks, bought 47.8 percent of the securities, the most since they received 51.4 percent of the securities at the October 2006 auction. At the past five auctions, the group bought 30.8 percent on average.

Inflation Protection

“Five-year TIPS are superstar today and are of the few asset classes doing well, relative to the other markets,” said George Goncalves, chief fixed-income rates strategist at primary dealer Cantor Fitzgerald LP in New York. “TIPS offer an inflation hedge and offer diversification in fixed income, especially when all other yields are so low.”

The difference between rates on five-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices for the next five years, widened to 1.52 percentage points from 1.37 percentage points at the beginning of the month.

The previous record for notes sold in a week was $115 billion over the five days ended July 31, when the Treasury sold $6 billion in 20-year TIPS, $42 billion in 2-year notes, $39 billion in 5-year securities, and $28 billion in notes maturing in seven years.

Treasury has sold $1.6 trillion in notes and bonds to finance a budget deficit that reached a record $1.4 trillion in fiscal year 2009 that ended Sept. 30. Debt amounted to 9.9 percent of the nation’s economy, triple the size of the 2008 shortfall.

Average Maturity

After issuing $1.9 trillion of short-term securities to finance President Barack Obama’s efforts to end the worst recession since the 1930s, the Treasury plans to lengthen the average due date of its outstanding debt to 72 months from a 26- year low of 49 months. That may mean boosting sales of 10- and 30-year securities by 40 percent over the next year to $600 billion, according to FTN Financial in Memphis, Tennessee, driving down prices of longer-term securities.

“The talk by the Treasury pertaining to the extension of the debt will continue to weigh on the back-end of the market and allow the trading range to resolve toward higher rates going forward,” John Spinello, chief technical strategist in New York at primary dealer Jefferies Group Inc., wrote in a note to clients.

Fed Purchases

Replacing bills with bonds may drive up the so-called yield curve as the Fed keeps its target rate for overnight loans between banks unchanged near zero until the second quarter of 2010, according to the weighted average of 67 forecasts in a Bloomberg survey. The gap between yields on 2- and 10-year notes widened to 2.53 percentage points from 1.29 percentage points at the end of last year.

The Fed is scheduled on Oct. 29 to complete the $300 billion Treasury purchase program it began in March, part of its effort to cap consumer borrowing costs.

Fed Chairman Ben S. Bernanke and his fellow policy makers cut the target rate for overnight loans between banks to a range of zero to 0.25 percent at the end of 2008. They will keep the benchmark there until August, when central bankers will boost it to 0.5 percent, according to the median estimate of 47 economists surveyed by Bloomberg from Oct. 1 to Oct. 8.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Cordell Eddings in New York at ceddings@bloomberg.net.

Last Updated: October 26, 2009 16:28 EDT