July 11 (Bloomberg) -- Treasuries fell the most in three weeks on speculation the U.S. government won't allow Fannie Mae and Freddie Mac to fail, reducing demand for the safest assets.

Two-year notes led the declines after a person familiar with the matter said a takeover of one or both of the companies is among the options being considered by White House officials. The declines pared a weekly gain fueled by concern the mortgage lenders will need an infusion of capital to weather the worst housing slump since the Great Depression.

``The market has been driven over the past week by concerns relating to the possible collapse of Fannie Mae and Freddie Mac, and today we're seeing a reversal of those safe-haven flows,'' said Marius Daheim, a senior bond strategist in Munich at Bayerische Landesbank, Germany's second-biggest state-owned bank.

The yield on the benchmark two-year note rose 4 basis points to 2.44 percent by 7:07 a.m. in New York, reducing the week's decline to 9 basis points, according to bond broker BGCantor Market Data. The price of the 2.875 percent security due May 2010 slipped 3/32, or 94 cents per $1,000 face amount, to 100 26/32. A basis point is 0.01 percentage point.

The yield on the 10-year note advanced 3 basis points to 3.83 percent. It has fallen 16 basis points in the past week.

Fannie Mae slid 14 percent yesterday, down 67 percent this year, and Freddie Mac declined 22 percent. The mortgage lenders would have to post pretax losses and writedowns of about $77 billion before the U.S. would be compelled to start a rescue, according to estimates by Fox-Pitt Kelton and Friedman, Billings, Ramsey & Co.

Sentiment, Fed

Central banks, pension funds and other investors hold $5.2 trillion in debt sold by the two companies, exceeding the $4.6 trillion Treasury note market.

Fannie and Freddie, created to boost homeownership and promote market stability, own or guarantee about half the $12 trillion in U.S. home loans outstanding.

Two-year notes headed for a fourth weekly gain before an industry report that economists say will show U.S. consumer confidence this month fell to the lowest level since 1980 and investors cut bets the central bank will raise interest rates.

The Reuters/University of Michigan preliminary index of consumer sentiment declined to a 28-year low of 55.5 in July from 56.4 the previous month, according to the median forecast of economists surveyed by Bloomberg News before the report today.

Futures contracts on the Chicago Board of Trade show 86 percent odds Federal Reserve policy makers will keep the target for overnight loans between banks unchanged at 2 percent on Aug. 5, compared with 34 percent a month ago.

'Weaker Growth'

``I'm betting on the weak economy,'' said Kei Katayama, who helps oversee $1.6 billion of non-yen debt as a fund manager in Tokyo at Daiwa SB Investments Ltd., part of Japan's second- biggest investment bank. ``There's going to be weaker consumption and much weaker growth.''

The rally may pause for several weeks because of quickening inflation, and it will pick up later in 2008, sending two-year yields to less than 2 percent by Dec. 31, Katayama said. He is considering adding longer-maturity notes, those that will gain the most in a rally, he said.

Notes also dropped today because of concern that oil prices near a record will boost inflation, eroding the value of bonds' fixed payments.

Crude oil gained as much as 2.9 percent to a record $145.98 a barrel today. Prices have doubled in the past year.

The difference in yield between two- and 10-year notes was at 1.37 percentage points today, from 1.27 percentage points a month ago. The increase indicates investors are demanding extra compensation to own longer maturities, those most sensitive to rising costs for goods and services.

Inflation

The Labor Department's consumer-price index rose 4.2 percent in May, which shows Treasury notes don't yield enough to keep pace with rising costs in the economy. Ten-year notes have yielded about 2 percentage points more than the index on average over the past decade, according to data compiled by Bloomberg.

The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes widened to 2.50 percentage points, from 2.28 percentage points at the end of April. The figure, which reflects the inflation rate that traders expect for the next decade, increased to the most since March when oil peaked.

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net

Last Updated: July 11, 2008 07:12 EDT