Nov. 10 (Bloomberg) -- Treasuries gained after the government's first sale of three-year notes in 18 months attracted stronger-than-forecast demand.

Yields on two-year notes fell to an almost eight-month low. The $25 billion auction drew a yield of 1.8 percent, below the 1.867 percent average forecast of six bond-trading firms surveyed by Bloomberg News. Treasuries earlier rose as U.S. stocks retreated, boosting demand for government debt. Today's sale was the first of three this week totaling $55 billion, the biggest quarterly refunding in more than four years.

``It was pretty obviously a very strong auction,'' said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of the 17 primary government securities dealers required to bid at Treasury sales. ``It indicates that strong demand remains for short-end Treasuries and the Treasury's not yet being penalized for increasing supply significantly.''

Benchmark two-year note yields dropped 8 basis points, or 0.08 percentage point, to 1.25 percent at 2:09 p.m. in New York, according to BGCantor Market Data. That was the lowest since March 17. The 1.5 percent security maturing in October 2010 rose 5/32, or $1.56 per $1,000 face amount, to 100 15/32.

Yields on the benchmark 10-year note fell 4 basis points to 3.75 percent, below their 200-day moving average of 3.79 percent.

Indirect bidders, a class of investors that includes foreign central banks, bought 36.1 percent of the notes sold today, the most since May 2005, when they purchased 40.3 percent. Investors bid for 3.07 times the amount offered, the most since May 1998.

AIG Rescue

The U.S. revived the three-year note to help pay for the Treasury's $700 billion bank-rescue plan and fund a budget deficit projected to widen from last fiscal year's $455 billion as the economy shrinks and tax receipts slow. The Federal Reserve and the Treasury today enhanced a rescue package for American International Group Inc., almost doubling to $150 billion an initial bailout in September, as the insurer burns through cash.

The government plans to sell $20 billion in 10-year notes Nov. 12 and $10 billion in 30-year bonds Nov. 13 as part of its quarterly refunding, the biggest since February 2004. The Securities Industry and Financial Markets Association recommended trading close at 2 p.m. in New York and stay shut worldwide tomorrow for the U.S. Veterans Day holiday.

`Find a Home'

``The fear was that this particular auction was going to fare poorly because the three-year was on a short day, the holiday was coming and we have more supply coming'' this week, said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. ``Money has got to find a home somewhere, and there are a lot of products that don't exist anymore or institutions that just won't buy those products anymore.''

Government securities have returned 5.6 percent this year, after gaining 9.06 percent in 2007, according to Merrill Lynch & Co.'s U.S. Treasury Master index. Demand for U.S. government debt is being fueled by the risk of a global recession after a U.S. housing slump led to a seizure in credit markets and a retreat from all but the safest assets.

Goldman Sachs Group Inc. forecast the deepest recession since 1982, with the economy contracting 3.5 percent in the fourth quarter and 2 percent in the first three months of 2009.

18-Month Turnaround

It will take at least 18 months to turn around the U.S., even if President-elect Barack Obama ``does everything perfectly,'' Columbia University Professor Joseph Stiglitz, a Nobel Prize-winning economist, wrote in the Washington Post yesterday. The Treasury will begin holding talks with Obama's transition team this week on various programs, a spokeswoman said.

The Standard & Poor's 500 Index fell 0.6 percent, after gaining as much as 2.3 percent. The S&P has slumped 37 percent this year.

The difference between two- and 10-year yields increased to 2.50 percentage points as the shorter-maturity notes outperformed. That's the highest since October 2003, based on closing prices.

The yield gap reached a record of 2.74 percentage points in August 2003 after the Fed finished a series of 13 rate reductions. Typically, the spread is steepest as the central bank stops lowering borrowing costs and investors anticipate an economic recovery, according to Tony Crescenzi, chief bond strategist at Miller Tabak & Co. LLC in New York.

`Remain Depressed'

``I think yields will remain depressed and continue to decline here, particularly on the front end'' of the Treasury market, said Martin Mitchell, head government bond trader at the Baltimore unit of Stifel Nicolaus & Co. ``The Treasury needs to fund all these bailout programs they are announcing, and that could keep pressure on the curve and keep it relatively steep, and that could present a struggle for the long end.''

Two-year notes will trade in a range of 1.25 percent to 1.50 percent ``in the next few weeks,'' while 10-year notes will yield between 3.5 and 4 percent over the next six weeks, Mitchell forecast.

The Treasury today also auctioned $27 billion in three- month bills at a rate of 0.355 percent and $27 billion of six- month bills at a rate of 0.99 percent.

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Cordell Eddings in New York at ceddings@bloomberg.net;

Last Updated: November 10, 2008 14:13 EST