June 1 (Bloomberg) -- Treasury 10-year yields surged the most in eight months as stocks and commodities advanced on signs that the recession is receding, damping demand for the safety of government debt.

U.S. government securities fell for the first time in three days as yields on mortgage-backed bonds climbed, spurring investors to sell Treasuries as a hedge against rising interest rates. Reports showed manufacturing shrank at a slower pace and construction spending rose. The difference between two- and 10- year yields widened to 2.71 percentage points, approaching the record 2.76 percentage points set on May 27.

“Money is rotating out of Treasuries and into other areas,” said Thomas Roth, head of U.S. government-bond trading in New York at Dresdner Kleinwort, one of 16 primary dealers that trade with the Federal Reserve. “There has been a tremendous flight into Treasuries over the past year and if things get better we will see a flight out.”

The yield on the benchmark 10-year note rose 20 basis points, or 0.20 percentage points, to 3.67 percent at 4:03 p.m. in New York, according to BGCantor Market Data. The yield earlier rose as much as 27.74 basis points, the most since advancing 32.97 basis points on Oct. 8. The 3.125 percent security due in May 2019 dropped 1 5/8, or $16.25 per $1,000 face value, to 95 1/2.

Ten-year yields have risen more than 165 basis points since falling to a record low of 2.03 percent last year.

The yield on the 30-year bond climbed 18 basis points to 4.53 percent.

Mortgage Rates

The Standard & Poor’s 500 Index gained 2.6 percent.

“Equities are higher and we are seeing our market come off as a result,” said Martin Mitchell, head of government-bond trading at the Baltimore unit of Stifel Nicolaus & Co.

Rising yields are pushing rates on mortgage-backed bonds higher, leading holders of the securities to sell U.S. debt used as a hedge to protect portfolios against rising interest rates. The same trade helped drive 10-year Treasury yields to 3.75 percent last week, the highest since November.

“Given the back-up in mortgage rates we think there was more hedging to go,” said Carl Lantz, an interest-rate strategist in New York at primary dealer Credit Suisse Securities USA LLC. “We can get back up to 3.75 in 10s, but then we think that would be a good buying opportunity. At that point we think the mortgage trade would basically be played out.”

Yields on Washington-based Fannie Mae’s current-coupon 30- year fixed-rate mortgage bonds rose 29 basis points to 4.62 percent, up from 3.94 percent on May 20.

Increased Volatility

As mortgage rates rise, the expected average lives of bonds backed by the loans extend as potential refinancing drops, leaving holders with portfolios of greater-than-anticipated sensitivity to interest-rate change.

The hedging activity has driven volatility in the Treasury market higher. Merrill Lynch & Co.’s MOVE index, which measures price swings in Treasuries based on prices of over-the-counter options maturing in two to 30 years, rose to 165.4 on May 29, up from this year’s low of 105.6 reached April 15.

“A lot of that has to do with whether the Fed will increase purchases of Treasuries,” Roth said. “That has been the key driver.”

U.S. debt handed investors a 4.3 percent loss this year, on course for the first annual drop since 1999, according to Merrill Lynch & Co.’s Treasury Master Index.

Measure of Inflation

Manufacturing in the U.S. shrank in May at the slowest pace in eight months. The Institute for Supply Management’s factory index rose to 42.8 from 40.1 in April, according to the Tempe, Arizona-based group. Readings below 50 signal contraction.

The Fed’s preferred measure of inflation, a price gauge tied to spending patterns which excludes food and fuel, increased 0.3 percent, after a 0.2 percent increase a month before, and was up 1.9 percent from a year earlier.

“There’s a real debate on whether we should be worried about deflation or inflation,” said Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage- backed securities at Federated Investors in Pittsburgh. “More recently, the debate has turned to inflation.”

Foreign investors continue to buy Treasuries even as concern mounts about the government’s increasing debt load. The Fed’s holdings of Treasuries on behalf of central banks and foreign institutions rose by $68.8 billion, or 3.3 percent, in May, the third most on record, data compiled by Bloomberg show.

‘No One More Concerned’

Treasury Secretary Timothy Geithner said today in China, the biggest holder of U.S. debt, that President Barack Obama plans to cut the budget deficit to “roughly 3 percent.” That would be down from a projected 12.9 percent this year.

“No one is going to be more concerned about future deficits than we are,” Geithner told reporters on the way to two days of meetings intended to assure Premier Wen Jiabao and other officials that its U.S. assets are safe.

The U.S. may borrow a record $3.25 trillion this fiscal year ending Sept. 30, almost four times the $892 billion in 2008, according to Goldman Sachs Group Inc., another primary dealer. The U.S. budget deficit is projected to reach a record $1.75 trillion for the same fiscal year, according to the Congressional Budget Office.

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

Last Updated: June 1, 2009 16:09 EDT