Nov. 1 (Bloomberg) -- Treasuries rallied, led by the second-biggest gain in two-year notes this year, after equity analyst downgrades of Citigroup Inc. sparked stock market declines and boosted the appeal of government debt.

Bonds more than recouped losses triggered yesterday by the Federal Reserve's indication that it doesn't anticipate reducing borrowing costs again this year. The cut in ratings of the largest U.S. bank was based on projections that rising delinquencies on mortgage loans will lead it to write down the value of assets.

``The market's convinced that the Fed can be bullied into lowering rates further if there appears to be some sort of systemic risk,'' said John Hendricks, a government bond portfolio manager in Hartford, Connecticut, at Hartford Investment Management Co. The firm oversees $137 billion of bonds.

Yields on two-year notes fell 19 basis points, or 0.19 percentage point, to 3.76 percent at 4:12 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 3 5/8 percent securities maturing in October 2009 rose 3/8, or $3.75 per $1,000 face amount, to 99 3/4. Yields move inversely to bond prices.

The last time two-year note yields fell more than today was on Aug. 9, when money-market rates surged because banks were reluctant to lend to one another.

`Work to Do'

Short-maturity Treasuries are ``anticipating the Fed has more work to do before they can feel satisfied that the U.S. economy not only is growing but that all sectors of the economy are getting back on their feet,'' said Daniel Shackelford, part of a team that manages $13 billion in Baltimore at T. Rowe Price Group Inc.

Traders increased bets on a quarter-percentage-point cut in the Fed's target for the overnight lending rate between banks at policy makers' next meeting on Dec. 11, interest-rate futures show. The implied probability of a cut rose to 60 percent from 42 percent, while the odds of no change fell to 40 percent from 58 percent, based on the prices of federal funds futures contracts listed on the Chicago Board of Trade.

The benchmark 10-year note's yield fell 13 basis points, the biggest drop in almost two years, to 4.34 percent, while the price of the 4 3/4 security maturing in August 2017 increased 1 1/32 to 103 7/32.

The gap between two- and 10-year yields widened for the first time in four days to 57 basis points from 52 basis points. The differential widened to 64 basis points last month, the biggest in two years, as traders wagered Fed rate cuts would lead to faster economic growth and inflation.

Ratings Cut

The equity ratings of Citigroup and Bank of America Corp. were lowered by CIBC World Markets and Morgan Stanley. Banks and other financial-services companies led the Standard & Poor's 500 Index of large-company shares to a 2.4 percent drop, its biggest in almost two weeks.

Credit Suisse Group, Switzerland's largest bank, today announced $1.9 billion of writedowns of fixed-income securities and leveraged loans in the third quarter.

``These credit stories have re-emerged,'' said Thomas Tucci, head of U.S. government bond trading in New York at RBC Capital Markets. Banks ``have to address this problem before year-end,'' with disclosures of losses ``affecting equity prices as well as Treasury prices.''

In a sign of rising risk aversion, the difference between the three-month London interbank offered rate and the three- month Treasury bill's yield increased to 107 basis points from 98 basis points.

Inflation Gauge

Treasuries also rose as a government report showed a measure of inflation watched by the Fed was stable and a private gauge of manufacturing fell more than forecast.

The Commerce Department's price index for personal consumption expenditures excluding food and energy, which the Fed forecasts will increase 1.75 percent to 2 percent next year, rose 1.8 percent in September from a year earlier, the same as in August.

The Institute for Supply Management's factory index fell in October to 50.9, the lowest in seven months, from 52 in September. Readings greater than 50 signal expansion. The median forecast was for a smaller decline to 51.5.

The two-year note's yield increased 14 basis points to a two-week high yesterday after the Fed cut its benchmark lending rate a quarter-percentage point to 4.5 percent.

Sept. 18 Meeting

At their previous meeting on Sept. 18, policy makers reduced the target rate by a half-percentage point from 5.25 percent, citing the potential for the biggest housing slump since 1991 to damp economic growth.

Yesterday's cut in borrowing costs by the Fed, ``combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets,'' the Federal Open Market Committee said in a statement accompanying the decision.

Inflation risks also may keep the central bank from lowering rates further, the FOMC statement said.

Crude oil rose above $96 a barrel for the first time in New York after U.S. inventories unexpectedly fell to a two-year low.

The Fed today added $41 billion in temporary reserves to the banking system, the largest one-day cash infusion since the terrorist attacks of September 2001. The amount reflects the central bank's effort to push the effective rate lower after policy makers reduced their target yesterday.

To contact the reporters on this story: Elizabeth Stanton in New York at estanton@bloomberg.net; Sandra Hernandez in New York at shernandez4@bloomberg.net.

Last Updated: November 1, 2007 16:15 EDT