Dec. 16 (Bloomberg) -- Treasury 30-year bond yields fell to an all-time low as a government report showed inflation dropped by the most on record last month and the Federal Reserve was forecast to cut borrowing rates to near zero percent.

Yields on two-year notes climbed for the first time in four days, with investors saying longer-term securities offered greater value as interest rates fall to record lows. Investors bet the Fed may also say it’s considering unconventional methods such as buying long-term debt to keep borrowing costs low. Traders saw 100 percent odds the central bank will cut interest rates at least a half-percentage point to the lowest on record.

“There are ample reasons in the real economy and on the inflation front for Treasuries to work their way to lower yields,” said Chris Ahrens, an interest-rate strategist at UBS Securities LLC in Greenwich, Connecticut, one of 17 primary dealers that trades with the Fed.

The yield on the 30-year bond fell four basis points, or 0.04 percentage point, to 2.92 percent at 1:45 p.m. in New York, according to BGCantor Market Data. It touched 2.9058 percent, the lowest since regular sales of the bond began in 1977. The price of the 4.5 percent security due in May 2038 rose 26/32, or $8.13 per $1,000 face amount, to 131 4/32.

The two-year note yield climbed nine basis points to 0.82 percent, and the five-year note yield gained four basis points to 1.53 percent. The yield on the 10-year note was little changed at 2.51 percent, after touching 2.465 percent, the lowest level since the beginning of Fed daily data in 1962.

The three-month bill rate rose to 0.04 percent, and one- month bill rates dropped to minus 0.03 percent.

‘Lower Lows’

The slowing economy has damped rising inflation concerns. Consumer prices dropped 1.7 percent last month, more than economists had forecast, a Labor Department report showed today in Washington. Excluding food and energy, so-called core prices were unchanged from a month earlier.

Goldman Sachs Group Inc. reported a fourth-quarter loss of $2.12 billion, the first since it went public in 1999.

Yields on 30-year Treasury bonds have fallen from a high of 4.81 percent six months ago. In that time, 10-year note yields have plunged from a high of 4.27 percent, while two-year securities have dropped from a high of 3.04 percent.

“Clearly we are making lower lows in yields and higher highs in prices as we clamp down on risk into year-end,” said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world’s largest inter-dealer broker. “It’s not about absolute rates, it’s allocation to safety.”

‘All Eyes on the Fed’

U.S. government bonds returned 12.7 percent this year, the most since they gained 13.4 percent in 2000, according to Merrill Lynch & Co.’s U.S. Treasury Master index.

The spread between two- and 10-year notes narrowed 10 basis points to 1.68 percentage points. It was 2.62 percentage points on Nov. 13.

Fed Chairman Ben S. Bernanke said in a Dec. 1 speech policy makers would consider buying longer-term government debt to prevent yields from rising. One option, he said, is to buy “longer-term Treasury or agency securities on the open market in substantial quantities.”

“It’s basically ‘all eyes on the Fed,’” said Matthew Moore, an interest-rate strategist in New York at Banc of America Securities LLC, another primary dealer. “I’m not clear whether they want a steeper curve to help banks, or a flatter curve to help long-term borrowing costs.”

Light Volume

Futures contracts showed a 52 percent chance the central bank will cut its 1 percent target rate for overnight bank loans to 0.25 percent. The rest of the bets are for a reduction to 0.5 percent.

A total of $45 billion in Treasuries changed hands yesterday. The volume was the least in a full day of trading since May 2, 2007, when $43.9 billion in government securities changed hands, according to ICAP Plc, the world’s largest inter- dealer broker.

The decline in inflation has driven the 10-year breakeven rate, the difference in yields between 10-year Treasury Inflation Protected Securities and comparable U.S. notes, to 0.13 percentage point, near the narrowest since the government started selling TIPS in 1997.

“The near-term deflationary forces are here in the numbers, and it will remain that way for the next several months,” said Kevin Flanagan, a Purchase, New York-based fixed- income strategist for Morgan Stanley’s individual-investor clients. “From an inflation standpoint, the kind of numbers we are seeing will not take us to levels outside of the realm of where we are now.”

TED Spread

Money-market rates showed banks’ reluctance to lend may be easing amid a global round of interest-rate reductions and cash injections. The difference between what banks and the U.S. government pay to borrow money for three months, the so-called TED spread, narrowed for a sixth day, to 1.81 percentage points, the lowest level since Nov. 11, from 1.86 points yesterday.

Gains in debt may be tempered after the Treasury said federal budget deficits are “likely to remain elevated for some time” as costs of financial bailouts and economic stimulus exceeded $1 trillion for the first time, analysts said.

The Treasury’s annual report yesterday showed government spending exceeded revenue by $1.01 trillion in the 12 months to Sept. 30, compared with $276 billion a year earlier, under stricter accounting methods used to calculate the shortfall.

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: December 16, 2008 13:49 EST