June 8 (Bloomberg) -- Treasuries fell, with the two-year note extending its biggest weekly slide in almost a year, on concern record U.S. debt sales may overwhelm demand as the economy shows signs of strengthening.

Ten-year notes tumbled for a third day as the government prepares to sell $65 billion in notes and bonds this week. The difference between two- and 10-year Treasuries narrowed to 248 basis points, the least since May 20, from a record 281 basis points last week, indicating investors are betting the Federal Reserve won’t keep its target interest rate near zero indefinitely as the economy begins to recover.

“People are diving out of the short end of the market,” said Michael Franzese, head of government bond trading for Standard Chartered in New York. “You have people who believe that there’s so much debt right now that interest rates will be going higher. That’s what’s pushing the market down.”

The yield on the two-year note rose 14 basis points, or 0.14 percentage point, to 1.43 percent at 4:27 p.m. in New York, according to BGCantor Market Data. The price of the 0.875 percent security maturing in May 2011 fell 9/32, or $2.81 per $1,000 face amount, to 98 29/32.

The yield on the 10-year note rose seven basis points to 3.90 percent, the highest level since Nov. 4.

Shorter-maturity notes tend to track the central bank’s target for overnight lending between banks, while longer maturities are more influenced by inflation.

Not ‘Anywhere Close’

Two-year yields surged 33 basis points on June 5, the most in eight months, after a Labor Department report showed U.S. job losses are abating and futures showed traders increased bets policy makers will raise borrowing costs before the end of 2009.

Traders see a 58 percent chance the Fed will raise its target rate by its November meeting, based on futures on the Chicago Board of Trade. The odds were 26 percent a week ago. The central bank cut its benchmark rate to a range of zero to 0.25 percent in December.

Rising unemployment and ongoing weakness in the housing market are likely to prevent the central bank from increasing rates in 2009. Fifteen of 16 primary dealers that trade Treasuries with the central bank surveyed by Bloomberg News today said they don’t expect the Fed to raise its target rate for overnight loans between banks this year. Officials at the 16th, Cantor Fitzgerald & Co., weren’t immediately available to provide a forecast.

“I don’t think the Federal Reserve is anywhere close to raising rates,” said Jan Hatzius, chief U.S. economist at primary dealer Goldman Sachs Group Inc., during a conference in Montreal. “The unusually deep recession of 2007 up to now is likely to be followed by an unusually weak recovery in 2009 and 2010.”

Record Borrowing

Treasuries have fallen 6.2 percent this year, heading for their first annual loss in a decade, according to Merrill Lynch & Co.’s U.S. Treasury Master Index, as President Barack Obama borrows record amounts to stimulate the economy and service budget deficits.

Obama 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. The budget deficit is projected to reach $1.85 trillion in the year ending Sept. 30 from last year’s $455 billion.

“Later in the week, we’ll have a ton of supply so we’re trying to figure out if Friday’s move to higher yields will be sustained,” said Ray Remy, head of fixed income in New York at primary dealer Daiwa Securities America Inc. “Right now the answer is yes but the market will start going up in prices after the auctions.”

The U.S. will auction $35 billion in three-year notes tomorrow, $19 billion in 10-year securities the next day, and $11 billion in 30-year bonds on June 11.

World’s Best Short

“The back end of the Treasury curve is probably the best short in the world,” said John Brynjolfsson, chief investment officer at Armored Wolf LLC. He spoke in an interview on Bloomberg Television. “Lending money to the Treasury for 30 years at a 4.5 percent yield is just totally illogical.” A short position is a bet the price of a security will decline.

The biggest price swings in Treasury bonds this year are undermining Fed Chairman Ben S. Bernanke’s efforts to cap borrowing rates and pull the economy out of the worst recession in five decades.

The yield on the 10-year Treasury note rose last week as volatility in U.S. debt hit a six-month high, according to Merrill Lynch’s MOVE Index of options prices. Thirty-year fixed- rate mortgages jumped to 5.45 percent from as low as 4.85 percent in April, according to Bankrate.com in North Palm Beach, Florida. Costs for homebuyers are now higher than in December.

Dramatic Volatility

Government bond yields, consumer rates and price swings are increasing as the Fed fails to say if it will extend the $1.75 trillion policy of buying Treasuries and mortgage bonds through so-called quantitative easing, traders say. The daily range of the 10-year Treasury yield has averaged 12 basis points since March 18, when the plan was announced, up from 8.6 basis points since 2002, according to data compiled by Bloomberg.

“Volatility has increased dramatically and it seems to get more each day,” said Thomas Roth, head of U.S. government-bond trading in New York at Dresdner Kleinwort, also a primary dealer. “A lot of that has to do with uncertainty about whether the Fed will increase purchases of Treasuries. The market is looking for some change in the Fed’s plan.”

The central bank bought $7.5 billion of U.S. debt maturing between May 2014 and April 2016 and will buy Treasuries due from August 2019 to February 2026 on June 10.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, which reflects the outlook among traders for consumer prices, was 1.99 percentage points, near the most since September. The figure has averaged 2.23 percentage points for the past five years.

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

Last Updated: June 8, 2009 16:32 EDT