Jan. 7 (Bloomberg) -- Treasuries fell as a record $30 billion auction of three-year notes added to concern debt sales will swell to unprecedented levels amid efforts by the U.S. to spur economic growth with spending increases and tax cuts.

Government debt has dropped 1.35 percent since December, the worst start of a year in at least two decades, according to Merrill Lynch & Co.’s U.S. Treasury Master Index. The U.S. budget deficit will more than double this year to $1.2 trillion, a Congressional Budget Office report said.

“Supply is weighing on the market,” said Ray Remy, head of fixed income in New York at Daiwa Securities America Inc., one of 17 primary dealers that trade with the Federal Reserve and are required to bid at government auctions.

Yields on benchmark 10-year notes rose three basis points, or 0.03 percentage point, to 2.49 percent at 4:45 p.m. in New York, according to BGCantor Market Data. The 3.75 percent security maturing in November 2018 fell 10/32, or $3.13 per $1,000 face amount, to 110 30/32. The yield has climbed 46 basis points since hitting a record low of 2.035 percent on Dec. 18.

Two-year note yields increased three basis points to 0.81 percent. Thirty-year bond yields added three basis points to 3.04 percent.

The Treasury tomorrow will hold its third note auction in as many days, a sale of $16 billion of 10-year securities, bringing the week’s total to $54 billion. Germany’s sale of 10- year bunds was scaled back after investors balked at its size.

‘Cheapened Up’

The three-year note sale drew a yield of 1.20 percent, the lowest on record. The security traded before the sale at 1.188 percent. The yield at the last auction, when $28 billion of the notes were sold on Dec. 10, was 1.245 percent.

Today’s sale drew less-than-average demand as judged by the bid-to-cover ratio, which compares the amount bid with the amount sold. It was 2.21, compared with an average ratio of 2.41 at the past 10 auctions. Indirect bidders, the class of investors that includes foreign central banks, bought 28 percent of the notes, compared with an average of 27.6 percent at the past 10 sales.

“It did not go as well as I thought it would,” said Charles Comiskey, head of U.S. Treasury trading in New York at HSBC Securities USA Inc., another primary dealer. “I was surprised, given that the three-year sector had cheapened up pretty nicely over the last week or so.”

Stock Correlation

Treasury yields rose even as stocks tumbled, with the Standard & Poor’s 500 Index losing 3 percent. The moves were the reverse of a more common correlation. Since Jan. 8, 2008, stocks and two-year Treasury yields both rose 79 percent of the time, according to Bloomberg data.

“Usually on a day when stocks are down 175 you would see the two-year note higher, and yet today we’re trading off,” Daiwa’s Remy said just after the auction. “That’s a direct result of supply.”

The U.S. economic outlook through the first half of 2009 is “grim,” and the first signs of economic recovery may not emerge until the third quarter, Kansas City Federal Reserve Bank President Thomas Hoenig said in the text of a speech today in Kansas City. He does not vote on interest rates until 2010.

The difference between yields on two- and 10-year Treasury notes was little changed from yesterday at 1.67 percentage points after widening by 42 basis points from 1.25 percentage points on Dec. 26.

‘Emotional Market’

Companies eliminated an estimated 693,000 jobs in December, an ADP Employer Services report showed today, the most since the firm’s records began in 2001. The Labor Department will report Jan. 9 that payrolls fell 500,000 in December, bringing last year’s job losses to 2.4 million, the most since 1945, according to the median estimate in a Bloomberg News survey of economists.

Price swings in the Treasury bond market declined, with Merrill Lynch & Co.’s MOVE index falling to 160.4. It was the lowest reading since Sept. 23, when policy makers were still debating the $700 billion bank-rescue plan. The gauge is still above the 102.7 average from 2000 through 2008.

The 10-year note’s yield yesterday closed above its 30-day moving average, a less volatile measure of price levels, for the first time in seven weeks. It was 2.46 percent; the moving average is 2.43 percent.

“The market has come off extremely fast, and I think there is some reason for support in yields,” said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world’s largest inter-dealer broker. “It’s still an emotional market, especially with the Fed buying mortgages and all the bearishness of bonds.”

‘Sinfully Low’

The Federal Reserve Bank of New York started purchasing mortgage-backed securities this week as part of a $500 billion program to support the U.S. housing market.

Yields suggest banks are becoming more willing to lend. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 1.31 percentage points from 2008’s high of 4.64 percentage points in October.

A Merrill Lynch index of U.S. corporate bonds showed they yielded 7.70 percentage points more than Treasuries, narrowing from 8.96 percentage points in the middle of December.

Germany failed to sell the full 6 billion-euro ($8.2 billion) amount of debt on sale in an auction today. Instead, the government sold 4.1 billion euros of its 3.75 percent securities due January 2019. The bid-to-cover ratio was 0.86.

“We have ongoing concerns that 2009 will be the year where the Treasury supply and demand curves diverge,” wrote UBS Securities LLC analysts led by William O’Donnell in a note today. “The best evidence of that creep toward divergence can probably be seen in the very long end” of the Treasury market.

The CBO’s deficit estimate for this year doesn’t include the cost of President-elect Barack Obama’s pending economic stimulus package, which will likely add at least $750 billion to the total over the next two years.

“I see no reason, other than somebody being patriotic, to own Treasuries,” Thomas Sowanick, who manages $20 billion as chief investment officer of Princeton, New Jersey-based Clearbrook Financial LLC, said in a Bloomberg Radio interview. “Yields are sinfully low.”

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

Last Updated: January 7, 2009 16:52 EST