June 4 (Bloomberg) -- Treasuries fell for the first time in three days after a government report showing the decline in the labor market may be stabilizing raised speculation the worst of the recession may be over.

Yields on 10-year notes approached a six-month high as initial jobless claims fell and traders increased bets tomorrow’s nonfarm payrolls report may be better than forecast. The difference between two- and 10-year notes steepened to a record 2.793 percentage points as the U.S. announced it would auction $30 billion in 10- and 30-year securities next week.

“The data was a little bit better,” said James Combias, New York-based head of Treasury trading at Mizuho Securities USA Inc., one of the 16 primary dealers that trade with the Federal Reserve. “People are squaring up positions for tomorrow’s employment report.”

The yield on the 10-year note rose 17 basis points, or 0.17 percentage point, to 3.71 percent at 4:52 p.m. in New York, according to BGCantor Market Data. The price of the 3.125 percent security due in May 2019 fell 1 11/32, or $13.44 per $1,000 face amount, to 95 5/32.

First-time jobless claims fell by 4,000 to 621,000 in the week ended May 30, in line with forecasts, from a revised 625,000 in the prior week, the Labor Department said today in Washington. Continuing claims for unemployment benefits dropped, breaking a string of 17 consecutive records, to 6.74 million in the week ended May 23 from 6.75 million the prior week.

Indicator Improvement

The payrolls report tomorrow will show job losses of 520,000 in May and U.S. unemployment passing 9 percent for the first time in 25 years, according to the median estimates in Bloomberg News surveys of economists.

“Every labor market indicator has improved relative to April,” economists at primary dealer Goldman Sachs Group Inc. in New York led by Jan Hatzius wrote in a note to clients. The economists lowered their May job-loss forecast to 475,000 from the 525,000 previously expected. Their forecast for the unemployment rate remains at 9.2 percent.

The increase in Treasury yields have also driven rates on mortgage-backed bonds higher, leading holders of the securities to sell U.S. debt used as a hedge to protect portfolios against rising interest rates. The same trade helped drive 10-year Treasury yields to 3.75 percent last week, the highest since November.

“There is mortgage selling going on,” Mizuho’s Combias said. “The volatility is causing all the big mortgage portfolios to have to hedge.”

‘The Easy Trade’

The U.S. will sell $127 billion of bills, notes and bonds next week, including $35 billion in three-year securities, $19 billion in 10-year notes and $11 billion in 30-year bonds, the Treasury said today. The government will also sell $31 billion in three-month bills and $31 billion in six-month bills.

Fed Chairman Ben S. Bernanke said in congressional testimony yesterday that large budget deficits threaten financial stability. Deficit concerns are already influencing the prices of long-term bonds, he added. Yields climbed to 3.75 percent on May 28, the highest level since November, increasing from a record low of 2.04 percent on Dec. 18.

“The easy trade right now is to sell prior to the supply,” said Thomas L. di Galoma, head of U.S. rates trading at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors. “Supply will be the issue.”

Treasuries have lost 4.7 percent this year, according to Merrill Lynch & Co.’s U.S. Treasury Master Index, amid concern record supply will outpace demand.

The budget deficit is projected to reach $1.85 trillion in the year ending Sept. 30 from last year’s $455 billion shortfall, according to the Congressional Budget Office. President Barack Obama may borrow a record $3.25 trillion this fiscal year ending Sept. 30, almost four times the $892 billion in 2008, according to Goldman.

Mortgage Bonds

The Fed bought $7.5 billion in U.S. debt maturing from May 2011 to April 2012 today, part of a plan to acquire up to $300 billion of Treasuries over six months to lower consumer borrowing costs.

Rising yields have complicated the central bank’s mission. The average rate on a 30-year home loan rose to 5.29 percent for the week ending today from 4.91 percent a week earlier, Freddie Mac, the McLean, Virginia-based mortgage buyer, said today in a statement.

Yields on Washington-based Fannie Mae’s current-coupon 30- year fixed-rate mortgage bonds rose 19 basis points to 4.72 percent, up from 3.94 percent on May 20.

As mortgage rates rise, the expected average lives of mortgage bonds extend as potential refinancing drops, leaving holders with portfolios of longer-than-anticipated durations. Duration is a measure of bond price sensitivity to interest-rate change.

Ted Spread

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, reflecting the outlook among traders for consumer prices, was 1.92 percentage points, close to the highest since September. The spread averaged 2.23 percentage points over the past five years.

Central banks’ efforts to revive credit markets are showing some signs of success. The gap between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, was 49 basis points, near the lowest level since 2007.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: June 4, 2009 16:58 EDT