Oct. 30 (Bloomberg) -- Treasuries dropped, pushing 10-year yields to the highest in two weeks, amid concern U.S. efforts to unfreeze credit markets and prop up the financial system will swell sales of government debt.

Bonds also declined after the third note auction this week, a $24 billion sale of five-year securities, drew stronger-than- average demand. U.S. borrowing needs will almost double this fiscal year to $2 trillion, Goldman Sachs Group Inc. forecast. The U.S. reported gross domestic product shrank 0.3 percent in the third quarter.

``What we're dealing with -- and it's reflected in yields and the curve shape -- is we're accommodating supply,'' said David Ader, head of U.S. government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut, one of the 17 primary dealers that trade with the Federal Reserve. ``This is about supply. This is taking yesterday's twos, today's fives, and threes, 10s, and 30s down the road.''

The yield on the benchmark 10-year note climbed 11 basis points, or 0.11 percentage point, to 3.97 percent at 4:56 p.m. in New York, according to BGCantor Market Data. It touched 3.98 percent, the highest since Oct. 20. The 4 percent security due in August 2018 dropped 29/32, or $9.06 per $1,000 face amount, to 100 7/32.

The two-year note's yield gained 2 basis points to 1.56 percent. Five-year yields increased as much as 12 basis points before the auction to 2.84 percent, the highest level since Oct. 20. They were 2.80 percent after the sale.

Treasuries have returned just 0.26 percent this month, the least since they fell 1.21 percent in May, according to Merrill Lynch & Co. indexes.

Three-Year Notes

The difference in yield, or spread, between two- and 10- year securities grew to 2.40 percentage points, the widest since February 2004, from 2.07 a week ago. The so-called yield curve has steepened as longer-term securities lagged behind in anticipation of increased government debt auctions.

The Treasury is scheduled to announce on Nov. 5 how it will boost the sales. It has said it will have a decision at that time on reviving the three-year note and holding more frequent 10- and 30-year debt sales.

The department should consider holding so-called reopenings of two-year note auctions on a monthly basis because demand for the maturity is strong enough, Goldman said in an Oct. 29 note.

The Fed cut its benchmark interest rate by half a percentage point yesterday to 1 percent, the lowest level since June 2004, saying ``downside'' risks to growth remain.

Economy Contracts

The economy declined in the third quarter the most since 2001, ushering in what may be the worst recession in a quarter century. GDP contracted at a 0.3 percent annual pace, a Commerce Department report showed today in Washington.

``This is the beginning of the recession,'' said Kevin Flanagan, a fixed-income strategist at Morgan Stanley Global Wealth Management Group in Purchase, New York. ``When history gets written about all that's occurred here, the third quarter of 2008 will probably be the first in a string of consecutive negative GDP readings.''

The auction of five-year notes, which matched the largest sale of the maturity since 2003, drew a yield of 2.825 percent, compared with a 3.129 percent yield at the last five-year sale. Investors bid 2.28 times the amount of debt offered. At the last auction, on Sept. 25, the figure was 1.91 times. The average for the past 10 sales is 2.12.

The government may also be prompted by record failed government-securities trades to address a scarcity of U.S. debt by reopening past Treasury issues.

Libor Falls

Banks' cost of borrowing dollars overnight fell to a record low, according to the British Bankers' Association. The London interbank offered rate, or Libor, that banks charge each other for overnight loans in dollars tumbled 41 basis points to 0.73 percent, 27 basis points below the Fed's target rate.

Yields indicate banks are more willing to lend than they were almost three weeks ago. The difference between what they and the Treasury pay to borrow money for three months, the so- called TED spread, narrowed to 2.82 percentage points from a high of 4.64 percent Oct. 10.

Corporate borrowing in the U.S. commercial paper market soared the most on record, the first gain in seven weeks, after the Fed began buying the debt directly from issuers this week. The amount of corporate IOUs outstanding rose by $100.5 billion, or 6.9 percent, to a seasonally adjusted $1.55 trillion for the week ended Oct. 29, according to Fed data.

``Another reason why bond yields may be higher is because there is a whole bunch of economic stimulus that has come to us through these facilities, and Libor is getting better,'' said James Caron, head of U.S. interest-rate strategy at primary dealer Morgan Stanley in New York.

`Default Seems Remote'

Investors can earn extra yield by buying so-called agency bonds issued by Fannie Mae and Freddie Mac, the two largest providers of funds for mortgages, said Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. The U.S. seized the pair last month. Gross said he also recommends the debt of banks that have sold stakes to the government.

``With Uncle Sam as your partner, default seems remote,'' Gross said in a monthly commentary on the Web site of Newport Beach, California-based Pimco.

Fannie's five-year notes yielded 1.40 percentage points more than Treasuries, Bloomberg data show. The spread narrowed from 1.52 percentage points on Oct. 27, which was the most since Bloomberg began tracking the figure in 1997.

To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Cordell Eddings in New York at ceddings@bloomberg.net

Last Updated: October 30, 2008 17:05 EDT