Dec. 13 (Bloomberg) -- U.S. Treasury notes fell after government reports showing the fastest increase in producer prices in 34 years and a gain in retail sales led traders to pare bets on lower interest rates.

Ten-year notes extended the biggest drop in more than two months, posted yesterday after the Federal Reserve and four other central banks said they would take extra steps to inject cash into lending markets. Interest rates on bank loans in euros held near a seven-year high, suggesting the measures haven't succeeded in spurring banks to lend to each other.

Climbing inflation ``is the fear the Fed has,'' said Brian Brennan, a portfolio manager who helps oversee $11 billion in fixed income at T. Rowe Price Group Inc. in Baltimore. Policy makers are ``trying to balance financial markets and liquidity versus the real economy.''

The yield on the 10-year note rose about 3 basis points, or 0.03 percentage point, to 4.12 percent as of 11:37 a.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 4 1/4 percent security due in November 2017 dropped about 1/4, or $2.50 per $1,000 face amount, to 101 1/32. The yield has climbed from a three-year low of 3.79 percent on Nov. 26.

Interest-rate futures on the Chicago Board of Trade show traders reduced bets on steeper Fed rate cuts in coming months. The chances the Fed will drop its benchmark rate by a half- percentage point to 3.75 percent in the next three months were 52 percent, from 69 percent a week ago. The likelihood of a quarter-point cut next month is 100 percent.

`Incremental Mode'

The so-called TED spread, the difference between three- month Treasury bill yields and the London interbank offered rate for the same maturity, fell to 2.10 percentage points, from 2.2 points yesterday, after earlier reaching the highest since August, a sign banks are charging more for loans. Three-month bill yields touched 2.75 percent today, the lowest since Aug. 20.

The jump in retail sales suggests consumer spending will weather the worst housing slump in 16 years, while the increase in producer prices may leave the Fed less room to reduce borrowing costs.

``Producer prices are showing some pretty strong inflation signs'' which may soon reach consumers, said Michael Franzese, head of government bond trading for Standard Chartered in New York. ``It keeps the Fed in an incremental mode.''

Sales increased 1.2 percent last month, double the median estimate in a Bloomberg News survey, government data showed. A separate report showed higher energy costs pushed wholesale prices up 3.2 percent last month, more than twice the median forecast. The gain in prices was the biggest since 1973.

`Additional Instruments'

The Fed has pared the benchmark overnight rate by 1 percentage point to 4.25 percent in the past three months. Throughout the rate cutting-cycle, Fed officials have highlighted longer-term inflation risks in their statements.

The cost to borrow euros for three months remained at a seven-year high of 4.95 percent, the British Bankers' Association said today. That's 95 basis points more than the European Central Bank's benchmark rate, compared with an average of 25 basis points in the first half of the year, before losses on U.S. subprime mortgages roiled credit markets. The rate remained elevated a day after the Fed joined four central banks in an attempt to end a logjam in money markets.

Fed Bank of New York President Timothy Geithner said central bankers are looking at ``additional instruments'' to provide funds to banks in times of stress.

`Wall of Worry'

Central bankers around the world have started a ``coordinated review'' of how regulations may be influencing liquidity risk, Geithner said in a speech in New York today.

The Fed yesterday made up to $24 billion available to the European Central Bank and Swiss National Bank to increase the supply of dollars in Europe. It also plans four auctions, including two this month adding as much as $40 billion, to increase cash in the U.S.

``That's only one component of the wall of worry the bond market's dealing with,'' said Tom McGlade, a Treasury trader in Greenwich, Connecticut, at RBS Greenwich Capital, one of 20 primary securities dealers that trade directly with the Fed. ``Even if it helps alleviate the overnight funding pressures and buys the banking system some time, it doesn't change the fact that in longer-term markets, lending standards are going to be tighter.''

Price swings in U.S. government debt are the highest in four years. Merrill Lynch & Co.'s MOVE index, an options-based measure of expectations for Treasury volatility, rose to 142.8 yesterday, the highest since 2003.

The Treasury Department will sell $8 billion of 10-year notes today, a decrease of $5 billion from the last offering. The auction is a reopening, meaning the securities sold pay the same interest rate and mature on the same date as the notes sold last month.

To contact the reporters on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: December 13, 2007 11:40 EST