June 20 (Bloomberg) -- Treasuries rallied, posting their second weekly increase this month, as traders pared bets the Federal Reserve will raise interest rates before September amid signs that stress is returning to financial markets.

Demand for the safety of government debt rose as the cost of protecting corporate bonds from default increased to the highest in two months. Lehman Brothers Holdings Inc. forecast Fannie Mae and Freddie Mac, the two largest sources of U.S. home loans, may lose more money in the second quarter as the housing market deteriorates, and Merrill Lynch & Co. said regional bank stocks are in ``capitulation mode.''

``People had been looking for and hoping for some sort of end to writedowns,'' said James Collins, an interest-rate strategist at Citigroup Global Markets Inc. in Chicago, one of 20 primary dealers that trade directly with the Fed. ``With all of the uncertainty in housing and banking and the credit markets, it just does not seem reasonable to me that the Fed is going to raise rates.''

The two-year note yield fell 5 basis points, or 0.05 percentage point, to 2.88 percent at 4:24 p.m. in New York, according to BGCantor Market Data. The price of the 2.625 percent security due in May 2010 rose 3/32, or 94 cents per $1,000 face amount, to 99 1/2. The yield declined 15 basis points this week.

The yield on the 10-year Treasury dropped 5 basis points to 4.16 percent, and was down 9 basis points for the week.

In another sign policy makers may refrain from raising borrowing costs, yields on two-year notes fell 1.28 percentage points below those of 10-year notes. The gap was 1.22 percentage points last week.

Shift From Last Week

The declines marked a shift from last week, when two-year yields climbed 66 basis points, the most since 1982, after Fed Chairman Ben S. Bernanke said the central bank ``will strongly resist'' rising inflation expectations. His comment sparked speculation policy makers will begin reversing their seven rate cuts since September.

U.S. stocks retreated today, with the Standard & Poor's 500 Index declining for the third straight week, after analysts said worsening credit losses will reduce earnings at financial companies.

``Finally the market is realizing the financial sector is still very much under water,'' said Jessica Hoversen, a fixed- income analyst in Chicago at MF Global Ltd. ``All the factors say a safe haven is the way to go.''

`Fed Is Divided'

Traders see a 92 percent chance the Fed will leave its 2 percent target rate for overnight lending between banks unchanged at its meeting on June 25, up from 78 percent a week ago, futures on the Chicago Board of Trade show. The probability it will lift rates at its August meeting has slipped to 38 percent from 65 percent a week ago.

Recent reports in such publications as the Financial Times and the Wall Street Journal, citing sources close to central bank officials, indicate ``the Fed is divided,'' said Dominic Konstam, head of interest-rate strategy at primary dealer Credit Suisse Securities USA LLC in New York.

``It's not totally committed to taking back rate cuts quickly,'' Konstam said.

Oil rose today after the New York Times reported an Israeli military exercise early this month could have been a rehearsal for an attack on Iran's nuclear facilities.

Citigroup Inc. said yesterday it expects ``substantial'' additional writedowns and more losses on consumer loans. On June 16, 76 banks bid at the Fed's auction of $75 billion in Term Auction Facility loans, indicating a widespread need for funding. It was the most banks bidding since April 21, when 83 submitted offers.

Treasury Note Auctions

The Treasury said yesterday it will auction $20 billion of five-year notes on June 26, the biggest offering of that security since February 2003, when the government sold $24 billion of the debt. It will sell $30 billion of two-year notes on June 24, the same amount as its last offering on May 28.

The Fed will raise its target rate to 2.25 percent in the second quarter of 2009, according to a Bloomberg News survey of economists, with the most recent forecasts given the heaviest weightings.

The U.S. economy will expand 1.4 percent in 2008 and 1.9 percent in 2009, slowing from 2.2 percent last year, Bloomberg surveys of economists show.

U.S. government securities have handed investors a loss of 0.7 percent so far in June, according to Merrill Lynch & Co.'s Treasury Master Index.

TIPS Yields

Treasuries had their biggest two-month loss in April and May since 2004 as oil prices surged and Fed officials intensified indications they'd shifted their focus from spurring growth to fighting inflation. Government debt lost a combined 2.9 percent in the two months ended in May, trimming gains so far this year to 0.7 percent.

The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes narrowed to 2.50 percentage points from 2.52 percentage points a week ago. The figure, which reflects the inflation rate that traders expect for the next decade, has climbed from 2.28 percent at the end of April.

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

Last Updated: June 20, 2008 16:30 EDT