Oct. 7 (Bloomberg) -- Treasuries fell, snapping the longest rally in a month, after the Federal Reserve announced a plan to buy commercial paper in an effort to thaw short-term lending markets, sapping demand for the haven of government debt.

Two-year notes fell for the first time in five days as the Fed invoked emergency powers to support the financing needs of corporations. Spain became the first European government to bail out its banks, while U.K. officials neared a similar agreement. Banks bid for less than the entire $150 billion in three-month loans under the U.S. central bank's expanded lending program.

``It's partially good news coming through,'' said William Hornbarger, a fixed-income strategist at Wachovia Securities in St. Louis. ``Time and capital is what the market needs. We've started to see where the capital is going to come from, now we need time.''

The yield on the two-year note rose 3 basis points, or 0.03 percentage point, to 1.46 percent at 4:16 p.m. in New York, according to BGCantor Market Data. The 2 percent security maturing in September 2010 dropped 2/32, or 63 cents per $1,000 face amount, to 101 2/32. The 10-year note yield increased 4 basis points to 3.50 percent.

Treasuries pared losses after Fed Chairman Ben S. Bernanke signaled in a speech policy makers are ready to cut interest rates as the credit freeze dims the outlook for economic growth and inflation concerns wane.

Special-Purpose Vehicle

Traders reduced bets the Fed will cut its 2 percent target rate for overnight bank lending by three-quarters of a percentage point at its Oct. 29 policy meeting. Futures contracts on the Chicago Board of Trade show a 32 percent chance the central bank will lower the rate to 1.25 percent, down from 58 percent odds yesterday. The rest of the bets are for a half- percentage point cut.

The Fed said it will buy commercial paper, lending against a special-purpose vehicle at the targeted federal funds rate. The unit will purchase from eligible issuers three-month dollar- denominated paper at a spread over the three-month overnight- indexed swap rate, according to a statement in Washington today.

The central bank will purchase asset-backed commercial paper, and in cases where the short-term loans are not secured by assets, it will collect fees or other securities.

Results of the Fed's $150 billion auction of loans under its Term Auction Facility suggest its decision yesterday to double the amount available is helping to meet demand for cash from financial institutions.

TED Spread

Rates on commercial paper, or short-term IOUs sold by companies, have soared in recent days as banks lost trust in corporate borrowers. After the Fed's announcement, yields on overnight U.S. commercial paper dropped 74 basis points to 2.94 percent, according to data compiled by Bloomberg. Borrowing for seven days increased 1.25 percentage points to 4 percent.

The TED spread, or the difference between what banks and the U.S. Treasury pay to borrow money for three months, narrowed to 3.54 percentage points today from 3.82 percentage points yesterday.

Three-month Treasury bill rates rose 32 basis points, to 0.78 percent. They touched 0.02 percent Sept. 17. Since then the central bank has sold $79 billion of the bills in regularly scheduled auctions and $200 billion in cash management bills of all maturities.

`Major Downturn'

Credit markets remain congested. The cost of borrowing in dollars overnight jumped more than 1 percentage point, the British Bankers' Association said today. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 157 basis points to 3.94 percent, BBA data showed today.

A measure of volatility in the Treasury market reached an all-time high yesterday. Merrill Lynch & Co.'s MOVE index, an options-based gauge of changes in prices for Treasuries, surged to 217.3, the highest since its creation in 1988.

Global growth is headed for a ``major downturn'' next year, as U.S. gross domestic product grinds close to a halt, the International Monetary Fund said in a report prepared for a Group of Seven meeting this week.

``Bernanke was alluding to much weaker economy and much lower inflation,'' said Francis Mustaro, who heads a group managing about $500 million at J&W Seligman & Co. in New York. ``The risks to growth are on the downside, no question.''

`Huge' TIPS Sell-Off

Inflation expectations are the lowest in almost a decade. The difference between rates on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional bonds narrowed to 1.17 percentage points, the lowest since April 1999. The spread reflects the outlook among traders for inflation over the next decade.

``You've seen this huge sell-off in TIPS,'' said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. ``Inflation expectations are quite low because the economy is getting wrung out.''

The median forecast of 77 economists surveyed by Bloomberg News is for the inflation rate to fall to 2.80 percent in 2009, compared with a forecast of 4.50 percent for the end of this year.

The U.K. government is preparing to inject at least 45 billion pounds ($79 billion) in three of the country's biggest banks in an effort to bolster capital depleted by mortgage- related losses, three people with knowledge of the situation said. Spain pledged to spend up to 50 billion euros ($68 billion) to buy assets from its troubled banks.

To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: October 7, 2008 16:20 EDT