July 6 (Bloomberg) -- Treasury two-year notes rose for a third day as the Federal Reserve bought $7 billion in government securities and an auction of inflation-linked bonds drew the most demand in nine years.

Short-term debt gained while 10-year notes were little changed before this week’s auction of the securities, and the yield gap between them was at the steepest level in more than two weeks. U.S. service industries from retailers to homebuilders shrank in June for the ninth straight month. An auction of $8 billion of 10-year inflation-linked debt drew the most demand since 2000. Oil and other commodities declined.

“We are starting to see risk assets, which have really outperformed in the last three months, start to wobble,” William O’Donnell, the Stamford, Connecticut-based head of Treasury strategy at RBS Securities Inc., said in a Bloomberg Television interview. The firm is one of 16 primary dealers that trade with the Fed. “That has brought some money back to the Treasury market which is what we saw in the auctions two weeks ago and the TIPS auction today.”

The two-year note yield fell four basis points, or 0.04 percentage point, to 0.95 percent at 5:12 p.m. in New York, according to BGCantor Market Data. The rate touched 0.9252 percent, the lowest level since June 4. The price of the 1.125 percent security due in June 2011 increased 2/32, or 63 cents per $1,000 face amount, to 100 11/32. The 10-year note yield was little changed at 3.50 percent.

The difference in yield, or spread, between 2- and 10-year Treasuries increased to as high as 2.61 percentage points, the biggest gap on an intraday basis since June 19.

TIPS Auction

Oil extended a three-week decline, dropping 3.8 percent, and copper fell for a third day.

The 10-year TIPS auction draw a yield of 1.92 percent, below the 1.933 percent average forecast of seven bond-trading firms surveyed by Bloomberg News. Demand was stronger than at the last auction, judging by the bid-to-cover ratio, which was 2.51, the highest since 2000. The measure, which compares the number of bids with the amount of securities sold, compared with 2.25 at the previous sale in April.

Indirect bidders, a group that includes foreign central banks, bought 49.7 percent of the amount sold, compared with 26.2 percent in the prior auction. The levels of indirect bidders at recent auctions may have been affected by a rule change last month that eliminated a provision allowing some customer awards to be classified as dealer bids.

‘Attractive Levels’

“These are very strong numbers,” said Alex Li, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, another primary dealer. “TIPs have cheapened a lot over the last couple of weeks in terms of breakevens and real yields. These attractive levels have enticed investors.”

The difference between 10-year Treasury Inflation Protected Securities and nominal debt of the same maturity fell to 1.62 percentage points today, the lowest level since May 19. The yield gap reached a high of 2.13 percentage points June 10.

The Institute for Supply Management’s index of non- manufacturing businesses, which make up almost 90 percent of the economy, increased to 47 last month from 44 in May, according to the Tempe, Arizona-based group. The median forecast was for a reading of 46, according to the estimates of 64 economists surveyed by Bloomberg News. Readings below 50 signal contraction.

Treasury notes gained last week after a report showed larger-than-projected job losses in June and the highest unemployment rate, at 9.5 percent, in almost 26 years.

Fed Purchases

“The market is questioning the argument of those who suggest we are nearing a bottom,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “In the short term two years will perform better because of the return to the realization that we are not out of trouble yet.”

The Fed bought $7 billion of Treasuries maturing between January 2014 and March 2016 today as part of its program to purchase up to $300 billion in debt to cap borrowing costs as the government sells record amounts of debt to spur growth and service deficits. The central bank has bought $197.723 billion in U.S. debt through the operations, which began March 25.

Vice President Joe Biden said yesterday on the ABC News program “This Week” the administration of President Barack Obama “misread the economy” when it forecast unemployment would peak at 8 percent if Congress acted on the $787 billion fiscal stimulus package. Biden also said it was too early to discuss crafting another stimulus.

Unprecedented Sales

The TIPS sale was the first of four auctions this week, the first time since the Treasury began selling securities regularly in 1976 that it has held four coupon auctions in one week. The government plans to sell $35 billion of conventional three-year notes tomorrow, $19 billion of 10-year securities the next day and $11 billion of 30-year bonds on July 9.

“The story of the week will still be supply,” said Thomas Tucci, New York-based head of U.S. government bond trading at RBC Capital Markets, the investment-banking arm of Canada’s biggest lender.

Unprecedented U.S. debt sales may prevent a summer rally this year, even as the Fed buys back Treasuries, investors including Deutsche Bank AG said.

Yields on benchmark 10-year U.S. notes fell from June through September in 15 of the last 20 years by an average of 35 basis points as the U.S. wrapped up the bulk of its debt auctions and investors reinvested the proceeds from interest and coupon payments.

After more than doubling note and bond offerings to $963 billion in the first half, another $1.1 trillion may be sold by year-end, according to primary dealer Barclays Plc. The second- half sales would be more than the total amount of debt sold in all of 2008.

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: July 6, 2009 17:15 EDT