Oct. 6 (Bloomberg) -- Treasuries rose as a tumble in stocks, weakness in credit markets and European bank rescues added to evidence a global credit crunch is deepening.

U.S. government debt had its longest rally in a month as investors sought a haven. Credit markets remained closed, with even municipal borrowers unable to find buyers for their debt. Rates on commercial paper, or short-term IOUs sold by companies, soared and the interest banks charge each other for overnight dollar-denominated loans in London increased. Emerging-market bonds weakened for a fourth straight day.

``Fear and unease are growing on a daily basis,'' said Mark MacQueen, partner and portfolio manager in Austin, Texas, at Sage Advisory Services Ltd., which oversees $6.5 billion. ``There is a complete lack of liquidity in all markets except U.S. Treasuries. With the weak stock market combined with the bad global outlook, Treasuries have a huge fear bid.''

Two-year Treasury note yields plunged 15 basis points, or 0.15 percentage point, to 1.43 percent at 4:40 p.m. in New York, according to BGCantor Market Data. The 2 percent security maturing in September 2010 climbed 9/32, or $2.81 per $1,000 face amount, to 101 3/32.

Ten-year yields dropped 15 basis points to 3.46 percent. They touched 3.42 percent, the lowest since Sept. 18.

Faltering Systems

Government bonds in Germany, the U.K., Canada and Japan also rallied as investors sought the safest assets while European governments rushed to shore up their faltering financial systems. Yields on German 10-year bunds, used as a benchmark for the euro-region, fell 17 basis points to 3.75 percent, while 10-year British gilts fell 19 basis points to 4.21 percent.

Major stock markets in the U.S. and Europe all fell 3.5 percent or more.

Germany's government and financial institutions agreed to a 50 billion euro ($68 billion) rescue package for Hypo Real Estate Holding AG, and BNP Paribas SA joined a state-backed bailout of Fortis, Belgium's largest financial-services company. Denmark and Germany also decided to guarantee all their countries' bank deposits.

Damage from the credit crunch accelerated over the past month as Lehman Brothers Holdings Inc. and Washington Mutual Inc. collapsed, the U.S. government took control of Fannie Mae, Freddie Mac and American International Group Inc., and Merrill Lynch & Co. and Wachovia Corp. were purchased by rivals.

Fed Moves

The Federal Reserve said it is doubling its emergency auctions of loans to commercial banks to as much as $900 billion as the credit freeze deepens, and will also begin paying interest on bank reserves. The central bank increased its auctions under the 28-day and 84-day Term Auction Facility operations to $150 billion each and boosted the two forward TAF auctions in November to $150 billion each.

``It's something that will help lending markets, but it certainly will be no panacea,'' said Michael Pond, an interest- rate strategist at Barclays Capital Inc., one of 17 primary dealers that trade with the Fed.

Yields on two-year notes fell to 2.03 percentage points below 10-year notes, the widest gap since March, as investors bet the turmoil will force the Fed to cut interest rates. The so-called yield curve will steepen to 2.75 percentage points, analysts at Credit Suisse Group AG wrote in a report today.

``The idea is the short end will rally more than the back end,'' said Dominic Konstam, the head of interest-rate strategy in New York at Credit Suisse Securities USA LLC, another primary dealer. ``The Fed is almost certainly going to cut rates soon, and that will underpin the front end.''

Fed Futures

Futures on the Chicago Board of Trade show a 48 percent probability the Fed will slash its 2 percent target rate for overnight bank loans by three-quarters of a percentage point to 1.25 percent at its Oct. 29 meeting. Traders saw no chance of a cut a month ago. The odds of a half-point reduction are 52 percent.

Losses from the credit crisis may rise to $1.7 trillion, leaving the $700 billion Troubled Assets Relief Program inadequate to clear toxic securities from banks' balance sheets, according to JPMorgan Chase & Co. analysts.

Fixed-rate municipal bond sales fell to about $800 million each of the past two weeks, after averaging more than $6 billion weekly this year, according to data compiled by Bloomberg. Yields on top-rated AAA general obligation debt due in 30 years averaged 5.35 percent, 53 basis points higher than on Sept. 11, based on a daily index from Municipal Market Advisors. That's almost 1.40 percentage points higher than similarly dated Treasuries.

Commercial Paper

``With so few issues being placed successfully, traders and institutional buyers are backing off their bids to incorporate an extra premium, because they cannot pinpoint the worth of a given bond,'' George Friedlander, a municipal strategist at Citigroup Inc. in New York, wrote in a weekly report to clients.

Yields on overnight U.S. commercial paper jumped 94 basis points to 3.68 percent, according to data compiled by Bloomberg. Companies sell debt maturing in nine months or less to help pay for day-to-day expenses such as payroll and rent.

Commercial paper outstanding tumbled $94.9 billion, or 5.6 percent, to a seasonally adjusted three-year low of $1.6 trillion for the week ended Oct. 1, according to the Fed. U.S. corporate bond sales shrank to $1.25 billion last week, marking the worst four-week slump since 1999, according to Bloomberg data.

The extra yield investors demand to own emerging-market bonds instead of Treasuries swelled 46 basis points to 4.86 percentage points, according to JPMorgan Chase & Co., the highest in more than four years. The spread was 3.19 percentage points a month ago.

More Supply

``In emerging markets, the credit crisis and drop in commodities create substantial challenges for monetary policy and fiscal accounts,'' said Igor Arsenin, an emerging-market fixed-income strategist at Credit Suisse in New York. ``Any country that needs capital in the form of foreign direct investment or portfolio flows is going to be vulnerable.''

The rally in Treasuries came even as the U.S. government said it is considering changes to its debt issuance, including a reintroduction of three-year notes. Any changes will be released at the department's quarterly refunding announcement Nov. 5.

Rising debt sales will push 10-year Treasury yields to 3.8 percent by year-end, strategists led by Ajay Rajadhyaksha in New York at Barclays Capital wrote in a report today. The two-year note yield has fallen below Barclays' 1.5 percent target.

`Tourniquet' Tightens

The financial-rescue bill enacted into law last week to unlock credit markets may do little to stem job losses, spur manufacturing or boost consumer confidence, strategists and economists at Dresdner Kleinwort and JPMorgan Chase & Co. said. They advise buying two-year notes, even though yields are already below the federal funds rate.

``The stresses in the money markets are running so high and liquidity is so bad that the economy really risks screeching to a halt as the credit tourniquet turns tighter here,'' said Robert Tipp, chief investment strategist for fixed income in Newark, New Jersey, at Prudential Investment Management, which oversees more than $200 billion of bonds.

UBS AG, the largest Swiss bank, said the Fed will cut its benchmark interest rate to 1 percent by March 31 from 2 percent, and lowered its forecast for global growth next year to 2.2 percent from 2.8 percent, economists led by Larry Hatheway in London wrote in a report yesterday. Goldman Sachs Group Inc. said last week the U.S. economy will shrink 0.2 percent in 2009, from a previous estimate of 1 percent growth. The Fed's target rate will be 1 percent by the end of March, the bank said.

``We now believe the world economy faces a recession,'' UBS said. The firm and Goldman are also primary dealers.

TED Spread

The so-called TED spread, the difference between what the U.S. government and banks pay to borrow in dollars for three months, was at 3.82 percentage points today. It averaged 39 basis points in the first half of 2007.

The cost of borrowing in dollars overnight jumped, the British Bankers' Association said today. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 37 basis points to 2.37 percent, BBA data showed.

U.S. government debt returned 1.2 percent since Sept. 30, beating last month's gain of 0.66 percent, according to Merrill Lynch & Co.'s U.S. Treasury Master index. Bonds gained 1 percent in Germany and 0.2 percent in Japan this month, Merrill indexes show.

To contact the reporter on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: October 6, 2008 16:52 EDT