Nov. 1 (Bloomberg) -- Treasury two-year notes had the biggest monthly gain since February after the Federal Reserve cut interest rates twice to spur a contracting economy and stocks tumbled amid a deepening credit crisis.

Two-year securities returned 1.1 percent in October, according to Merrill Lynch & Co.'s Treasury Master Index, for their fifth straight monthly advance. Three-month bills yesterday had the biggest weekly gain since September. This month's decline in U.S. stocks, the steepest in two decades, drove investors to the relative safety of short-term securities, the so-called front end of the Treasury market.

``The economy is still on tenterhooks,'' said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world's largest inter-dealer broker. Investors ``will put money into the front end in a more protectionary stance.''

Two-year note yields fell 41 basis points, or 0.41 percentage point, in October to 1.55 percent, according to data compiled by Bloomberg. Rates on three-month bills dropped 41 basis points on the week, the most since the five days ended Sept. 19, to 0.44 percent. Debt yields and prices move in opposite directions.

Yields rose this week as the U.S. sold $64 billion in debt and traders speculated the Treasury will say on Nov. 5 it plans to sell a new maturity to help fund a widening budget deficit. Two-year yields climbed 4 basis points, and five-year yields jumped 22 basis points. Rates on 10-year notes increased 27 basis points.

`Tug of War'

``Everything else being equal, yields will probably be marginally higher in order to digest all the supply,'' said Alex Li, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, one of the 17 primary dealers that trade bonds with the Fed. ``It's going to be a tug of war between the Street setting up for supply and the potentially weak economic data we're going to get.''

Two-year yields will rise to 1.59 percent by year-end, while 10-year rates will fall to 3.70 percent, according to the weighted average of forecasts in two Bloomberg News surveys. The government on Nov. 7 will probably say payrolls fell for a 10th straight month, according to a Bloomberg survey of economists.

Treasuries gained on Oct. 29 after the Fed reduced its target rate for overnight lending between banks by a half- percentage point to 1 percent, its second reduction in three weeks, and said downside risks to growth remain. Policy makers on Oct. 8 cut the rate in an emergency move coordinated with five other central banks.

Yield Curve

The difference between yields on two- and 10-year notes, known as the yield curve, widened to 2.40 percentage points this week, the most in almost five years, as two-year notes outperformed. Traders favored the shorter maturities amid speculation the Fed will keep cutting interest rates.

San Francisco Fed President Janet Yellen said after a speech in Berkeley, California, on Oct. 30 that the Fed may bring its main lending rate close to zero `because we are concerned about weakness in the economy.''

U.S. gross domestic product contracted by 0.3 percent from July to September, the Commerce Department said Oct. 30. It was the biggest decline since 2001. The Standard & Poor's 500 Index fell 17 percent in October, the biggest decline since its 22 percent drop in 1987. Treasuries of all maturities returned 0.04 percent last month and 4.6 percent on average in 2008, according to a Merrill's indexes.

TED Spread

Money-market rates indicated banks are more willing to lend after governments worldwide pumped capital into the financial system this month.

The London interbank offered rate, or Libor, for three- month dollar loans dropped for a third straight week, to 3.03 percent. The difference between what banks and the U.S. government pay for three-month loans, known as the TED spread, narrowed to 2.59 percentage points. It was 4.64 percentage points Oct. 10.

``The theme for the week has been and will be for the next couple of weeks, the meaningful improvement in Libor,'' said Michael Cloherty, head of U.S. interest rates strategy at Banc of America Securities LLC, another primary dealer. ``We are also starting to get much more attention to upcoming supply and there is attention on the upcoming refunding announcement,'' he said, referring to Treasury auctions.

Debt Sales

The Treasury this month said it will continue enlarging auctions of bills, notes and bonds and will announce any change to its debt offerings, including a possible revival of the three-year note, on Nov. 5. U.S. borrowing needs will almost double this fiscal year to $2 trillion, Goldman Sachs Group Inc. forecast this week.

The government's $34 billion sale of two-year notes on Oct. 28 drew a yield of 1.60 percent, the lowest since March 2004. The U.S. also auctioned $24 billion of five-year notes on Oct. 30 at a yield of 2.825 percent, below the rate drawn in the previous month's sale. A $6 billion auction of five-year Treasury Inflation Protected Securities on Oct. 27 came in at a yield of 3.27 percent, the highest since October 1997, the year TIPS were first sold.

TIPS yields indicate investors are betting consumer prices will fall. Five-year TIPS yielded 0.31 percentage points more than Treasuries of similar maturity this week. TIPS typically yield less than conventional notes because TIPS' principal payments are tied to inflation, and investors expect the inflation payout to make up the difference.

To contact the reporters on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net.

Last Updated: November 1, 2008 08:00 EDT