May 21 (Bloomberg) -- Treasuries fell, pushing yields on 10-year notes up by the most in two weeks, after the Federal Reserve bought a smaller amount of debt than some investors expected and the U.S. said it will sell $162 billion of notes and bills next week to finance the budget deficit.

The declines were led by longer-maturity notes and bonds, sending yields on 10-year securities to 2.5 percentage points above those on two-year notes, the most since November. Rising debt sales have contributed to a 3.3 percent loss for Treasury investors, the worst start to a year since 1994, according to Merrill Lynch & Co.’s U.S. Treasury Master Index.

“The Fed buybacks are over and it’s taken the market down,” said Michael Franzese, head of government bond trading for Standard Chartered in New York. “We thought the Fed would have bought more. Supply is carrying a heavy amount of weight. Supply keeps coming and there’s no end in sight.”

The yield on the benchmark 10-year note rose 16 basis points, or 0.16 percentage point, to 3.36 percent at 5:03 p.m. in New York, according to BGCantor Market Data. The 3.125 percent security due May 2019 fell 1 11/32, or $13.44 per $1,000 face amount, to 98.

Thirty-year Treasury bond yields surged 16 basis points to 4.31 percent, while two-year note yields increased one basis point to 0.85 percent.

Downgrade ‘Possibility’

Treasuries also fell, along with the U.S. dollar and the Standard & Poor’s 500 Index, after Standard & Poor’s lowered its outlook on the U.K.’s AAA credit rating today to “negative” from “stable,” raising concern that the same may happen to the U.S.

President Barack Obama’s administration has pushed the nation’s marketable debt to an unprecedented $6.36 trillion. It raised on May 11 its estimate for the deficit this year to a record $1.84 trillion, up 5 percent from the February estimate, and equal to about 13 percent of the nation’s GDP.

“The markets are beginning to anticipate the possibility of” a downgrade to the U.S.’s top rating, though “it’s certainly nothing that’s going to happen overnight,” Bill Gross, the co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., said in an interview today on Bloomberg Television. The firm manages the world’s biggest bond fund, the $150 billion Pimco Total Return Fund.

The U.S. will issue a record $3.25 trillion of debt in the fiscal year ending Sept. 30 to pay for a growing budget deficit, according to Goldman Sachs Group Inc., one of the 16 primary dealers that are obligated to participate in Treasury auctions.

Swine Flu

“Both the U.K. and the U.S. have prospective deficits of 10 percent annually as far as the eye can see,” Gross said. “At some point over the next several years” the debt of each “may approach 100 percent of GDP, which is a level at which country downgrades tend to occur,” he said.

Other investors discounted the possibility that S&P’s action on the U.K. implied the U.S. faced a downgrade of its sovereign credit rating.

“I think this may be an overreaction,” said Michael Cheah, who manages $2 billion in bonds at AIG SunAmerica Asset Management in Jersey City, New Jersey. “Just because the U.K. catches swine flu doesn’t mean the U.S. will catch swine flu too.”

The Treasury announced it will auction $40 billion in two- year notes on May 26, $35 billion in five-year notes on May 27 and $26 billion in seven-year notes on May 28. The Treasury will also sell $61 billion in three-month and six-month bills at its weekly auction on May 26.

“With the supply this market is facing, it has to go to higher yields to attract capital,” said Charles Comiskey, head of U.S. Treasury trading in New York at HSBC Securities USA Inc., another primary dealer.

Yield Curve

The difference between two- and 10-year notes, known as the yield curve, expanded by 15 basis points to 2.50 today. That’s the most since it grew 17 basis points on January 5. The spread reached a record of 2.74 percentage points in August 2003.

The difference between rates on 10-year notes and Treasury Inflation Protected securities, which reflects the outlook among traders for consumer prices, reached 1.73 percentage points, the highest level since September.

Today’s declines in Treasuries wiped out yesterday’s gains, which came after minutes of the Fed’s April 28-29 policy meeting showed some officials judged the central bank may need to boost asset purchases to secure a stronger economic recovery, while all agreed to hold off on such a move.

The central bank bought $7.398 billion, or 16 percent, of the $45.694 billion in U.S. debt due in 2013 to 2016 offered by dealers for consideration. At the last purchase of securities in the maturity range targeted today, the Fed bought 30 percent of the $23.388 billion offered.

‘Push Back’

“Dealers, by showing a larger-than-normal amount of supply, are indicating that they are better sellers at current prices,” Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, wrote in a note to clients today. “The Fed, in purchasing a smaller proportion than normal of what was offered by dealers, may have wanted to push back the dealer community after many concluded yesterday from the FOMC minutes that the Fed might either increase its Treasury purchases or be more aggressive with its purchases.”

The central bank bought $122.984 billion in U.S. debt through the purchase operations, which began March 25, as it seeks to lower borrowing costs. The next purchase will be on May 26, when the central bank will buy Treasury Inflation Protected Securities, or TIPS, maturing between January 2010 and April 2032.

To contact the reporter on this story: Susanne Walker in New York at swalker33@bloomberg.net.

Last Updated: May 21, 2009 17:20 EDT