Nov. 19 (Bloomberg) -- Treasuries rose, led by longer-term securities, after a government report showed consumer prices dropped in October by the most on record.

The difference between yields on 10-year Treasury Inflation Protected Securities and conventional notes, which reflects the outlook for consumer prices, was 38 basis points, near the least since Bloomberg began tracking the data in 1998. Two-year yields touched the lowest since 2003 as traders bet the Federal Reserve will cut interest rates to spur the economy. The Fed reduced its forecasts for growth and employment in 2009.

``The theme now seems to be one of deflation,'' said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. ``That's the fear at this point. That almost makes bonds look cheap.''

The benchmark 10-year yield tumbled 16 basis points, or 0.16 percentage point, to 3.36 percent at 4:17 p.m. in New York, according to BGCantor Market Data. It touched 3.35 percent, the lowest since Sept. 17, when the U.S. rescued insurer American International Group Inc. The 3.75 percent security due November 2018 climbed 1 3/8, or $13.75 per $1,000 face amount, to 103 1/4, gaining for a fourth day. The 30-year bond's yield dropped 17 basis points, the most since Sept. 29, to 3.95 percent.

The yield on the two-year note fell five basis points to 1.08 percent after earlier touching 1.06 percent, the lowest level since June 13, 2003. Rates on three-month bills touched 0.06 percent, the lowest since Sept. 19.

Fed Lowers Estimates

``We crammed into bills until there was no yield there,'' said Brian Edmonds, head of interest rates at Cantor Fitzgerald LP in New York, one of 17 primary dealers that trade with the Fed. ``We've kind of moved into two-year notes, but we're at a point where there's not much yield left there. The cash flows continue to be defensive.''

Fed policy makers at their meeting Oct. 28-29 predicted the U.S. economy will contract through the middle of 2009, and some were prepared to cut interest rates further in response, according to meeting minutes that were released today.

The central bank predicts growth next year of between negative 0.2 percent and 1.1 percent next year, compared with the range of 2 percent to 2.8 percent it had forecast in June, according to the records. The jobless rate is projected to be 7.1 percent to 7.6 percent.

Stocks fell, with the Standard & Poor's 500 Index losing 6.1 percent. It has dropped 20 percent since Nov. 4, the day Barack Obama was elected president.

Consumer prices plunged 1 percent last month, more than forecast and the most since records began in 1947, a Labor Department report showed. A Commerce Department report showed housing starts fell in October to an annual rate of 791,000, the lowest since records began in 1959.

30-Year Swap Rate

The price to exchange, or swap, floating for fixed-rate payments for 30 years fell below the yield on similar maturity Treasury bonds by the most ever as dealers hedged against risk related to derivatives. The yield on the 30-year Treasury bond was as much as 33 basis points higher than the 30-year swap rate. The swap rate has remained below the long bond's yield since Nov. 5.

Traders who needed to hedge derivatives contracts drove down long-dated interest-rate swap rates, which contributed to the rally in 10- and 30-year government debt, said Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc.

The gap between 10-year swaps and the 10-year Treasury note yield reached as low as 31 basis points, the most narrow since May 2003.

`Powerful Forces'

Traders exiting bets that the gap between the 10-year and 30-year interest-rate swap rates would widen may also be driving the 30-year swap rate lower, said Eric Liverance, head of derivatives strategy in Stamford, Connecticut at UBS Securities LLC, another primary dealer.

``These are powerful forces,'' Liverance said. ``You'd better get out of the way, or you're going to get run over.''

Futures on the Chicago Board of Trade show a 100 percent chance the central bank will reduce the 1 percent target rate for overnight bank loans by at least a half-percentage point at its Dec. 16 meeting. Odds of a three-quarter-point cut rose to 20 percent, from 12 percent yesterday.

The breakeven rate on two-year notes, which shows the difference in yield between inflation-protected bonds and nominal bonds, fell to a negative 3.84 percentage points, indicating traders are betting that slumping economic growth may lead to deflation over the next two years.

Yield Spread

The difference in yield between two- and 10-year notes narrowed for a fourth day, to 2.29 percentage points, reflecting bets that lower inflation expectations will support real returns in longer-dated bonds.

Treasuries returned 7.4 percent this year, while German government bonds handed investors 8.1 percent and Japanese sovereign securities earned 1.4 percent, according to indexes compiled by Merrill Lynch & Co.

CME Group Inc., the world's largest futures market, asked member firms to ensure they're prepared to meet delivery requirements on Treasury futures that expire in December. Surging demand for U.S. sovereign debt caused an increase in failed trades in the weeks following the Sept. 15 collapse of Lehman Brothers Holdings Inc. Uncompleted trades reached a record in October.

The government will announce tomorrow the size of auctions of two-year and five-year Treasuries next week. The U.S. sold a combined $58 billion of the maturities in October.

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Cordell Eddings in New York at ceddings3@bloomberg.net.

Last Updated: November 19, 2008 16:29 EST