May 14 (Bloomberg) -- Treasuries declined, sending 10-year yields to the highest level in four months, before a government report that economists estimate will show consumer prices rose.

Ten-year U.S. notes fell a third day as Federal Reserve officials said policy is being challenged by unacceptably high inflation, suggesting they are ready to pause in cutting interest rates.

``The focus is firmly back on inflation, and the chances of more rate cuts are declining further,'' said Peter Mueller, a fixed-income strategist in Frankfurt at Commerzbank AG, Germany's second-largest lender. ``We have less reason to expect lower yields, and we'll have a tendency to go for short positions.'' A short position is a bet that the value of a security will drop.

The benchmark 10-year note yield rose 3 basis points, or 0.03 percentage point, to 3.95 percent as of 8:02 a.m. in New York, according to bond broker BGCantor Market Data. The price of the 3 7/8 percent security due in May 2018 fell 5/32, or $1.56 per $1,000 face amount, to 99 6/32. The 10-year note probably will yield 4 percent ``or higher'' in the next two months, Mueller predicted.

Two-year yields increased 8 basis points to 2.55 percent.

Treasuries extended losses after Freddie Mac, the second- largest U.S. mortgage-finance company, posted a $151 million first-quarter loss and said it will raise $5.5 billion in capital. The net loss of 66 cents a share compared with the 84 cent average estimate of 11 analysts surveyed by Bloomberg. The company's shares surged more than 8 percent.

Yield Spread Narrows

The difference in yield, or spread, between 10-year and two- year Treasury yields narrowed to 1.41 percentage points today, the least in more than a week, as investors bet policy makers will keep interest rates on hold.

Notes fell yesterday after a bigger-than-forecast increase in retail sales excluding autos bolstered speculation the Fed will refrain from cutting interest rates next month following seven reductions since September.

Fed officials Janet Yellen, Sandra Pianalto, Thomas Hoenig and Richard Fisher said they're concerned about rising prices. Yellen and Dennis Lockhart, head of the Atlanta Fed, are scheduled to speak at separate events today.

Prices paid by U.S. consumers rose 0.3 percent last month, the same as in March, according to the median forecast in a Bloomberg News survey of economists. The Labor Department is due to release the report at 8:30 a.m. in Washington.

Inflation was an annualized 4 percent in April, the Bloomberg survey showed, which means the yields offered by Treasury notes aren't enough to keep up with rising prices for goods and services.

Inflation-Indexed Securities

Investor demand for a haven from rising prices that erode fixed-income returns has increased. The difference between yields on 10-year Treasury Inflation-Protected Securities, or TIPS, and conventional notes with the same maturity widened to 2.42 percentage points from 2.28 percentage points on April 30.

Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., called Treasuries ``totally overvalued'' as consumer prices rise, according to a report in AsianInvestor magazine.

Pimco has moved away from Treasuries and into high-quality credit-market securities, especially those issued by financial institutions, over the past four weeks, Hong Kong-based AsianInvestor reported. Pimco considers yields on bonds sold by American International Group Inc., Wells Fargo & Co., and JPMorgan Chase & Co. to be more attractive than those on Treasuries, according to the article.

More Reports Due

Declines in Treasuries may be limited as some investors bet the crisis in credit markets isn't about to end and that the world's largest economy will continue to slow. Reports later this week may show initial jobless claims rose last week and industrial production shrank last month, according to Bloomberg surveys of economists.

Fed Chairman Ben S. Bernanke said yesterday financial markets remain unsettled even as the central bank's attempts to boost lending had yielded ``some improvement.''

The U.S. may be in for a ``prolonged'' period of slow growth, because credit-crisis excesses have to be corrected, which may end with faster-than-desirable inflation, Fisher said in Midland, Texas. He voted against the last three rate cuts.

The U.S. economy expanded at a 0.6 percent annual pace in the first quarter, the same as the previous three months. The last time the economy grew more slowly was in the fourth quarter of 2002.

`Not Seen the Bottom'

``Given the gloomy outlook for the U.S. economy and the credit crisis still lingering, we remain of the view that we have not seen the bottom in yields yet,'' Wilson Chin, a fixed-income strategist in Amsterdam at ING Groep NV, the largest Dutch financial-services firm, wrote in a note to clients.

Treasuries have dropped as crude oil climbed to a record $126.98 a barrel in New York yesterday, and former Fed Chairman Alan Greenspan said the fuel will keep rising because companies have invested too little in production and infrastructure to cope with higher demand.

Greenspan, speaking via satellite to a conference sponsored by Deutsche Bank AG in Singapore, also said investors are still guessing at the extent of subprime-mortgage losses, according to a strategist who attended the event and asked not to be identified.

Traders expect the next Fed move will be to raise borrowing costs rather than reduce them. Futures contracts on the Chicago Board of Trade indicate the central bank will keep its main rate at 2 percent through September. The chance the rate stays unchanged by the end of the year is 30 percent, with the odds on an increase at 70 percent.

Fed Bank of Chicago President Charles Evans said the economy will pick up as the year progresses, though at a ``sluggish'' pace, in a speech yesterday in Chicago.

Measures of risk indicate the worst of the credit-market turmoil may have passed.

The gap between three-month bill yields and the three-month London interbank offered rate was at 88 basis points, from 147 basis points two weeks ago. The narrowing in the so-called TED spread indicates bank borrowing costs are declining.

To contact the reporters on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net

Last Updated: May 14, 2008 08:09 EDT