Nov. 20 (Bloomberg) -- Treasury yields tumbled to record lows, with two-year notes dropping below 1 percent for the first time, as global stocks slumped and a deepening recession drove investors to the safest assets.

Yields on two-, five- and 10-year notes and 30-year bonds dropped to the least since the Treasury began regular issuance of the securities as reports showed U.S. jobless claims surged and a drop in manufacturing. U.S. lawmakers postponed voting on a plan to rescue the auto industry, sending the Standard & Poor’s 500 Index to the lowest level in 11 years.

“It’s the continued meltdown of the financial system, lack of action by Washington,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “There’s no white knight coming to save us.”

The benchmark 10-year yield dropped 31 basis points to 3.02 percent at 4:48 p.m. in New York, according to BGCantor Market Data. The 3.75 percent security due November 2018 rose 2 22/32, or $26.88 per $1,000 face amount, to 106 1/32. The yield is the lowest since at least 1962. The yield on the 2-year note fell 9 basis points to 0.97 percent.

The 30-year yield tumbled 46 basis points to 3.46 percent, the biggest drop on record. The yield is the lowest since regular sales started in 1977. Yields on five-year notes declined to 1.88 percent, not seen since 1954, according to data compiled by Bloomberg and the Fed.

Direct Correlation

The Standard & Poor’s 500 extended its 2008 tumble to 49 percent, poised for the worst annual decline in its 80-year history. The S&P declined 6.7 percent to 752.44.

“It’s a direct correlation with stocks,” said Thomas Roth, head of U.S. government bond trading in New York at Dresdner Kleinwort, one of 17 primary dealers that trade with the Fed. “We are the fear indicator, we are the tail being wagged by the fear in the system.”

Treasuries are also attracting investors on speculation the Fed will cut interest rates next month. Two-year notes are seen as among the most secure assets and are also sensitive to changes in borrowing costs because of their short maturity.

Two-year notes returned 6.5 percent in 2008, compared with 7.5 percent last year, according to indexes compiled by Merrill Lynch & Co. The yield declined from 3.11 percent on June 13, the highest level this year.

Treasury Bill Rates

Demand for government debt increased as the Fed cut its target rate for overnight lending between banks by 4.25 percentage points to 1 percent in the past 14 months to prop up the economy, the world’s biggest. Jobless claims climbed to 542,000 in the week ended Nov. 15, the Labor Department said. The Conference Board’s index of leading economic indicators declined 0.8 percent, and a measure of manufacturing in the Philadelphia region fell to an 18-year low.

Rates on three-month bills dropped to 0.02 percent. That equals the level reached after the collapse of Lehman Brothers Holdings Inc. on Sept. 17, the lowest since the start of World War II.

Some Fed policy makers said they were prepared to cut interest rates further as “more aggressive easing should reduce the odds of a deflationary outcome,” according to minutes of the Oct. 28-29 meeting released yesterday.

Futures on the Chicago Board of Trade show a 62 percent chance the central bank will reduce its target rate by 50 basis points at its Dec. 16 meeting. The rest of the bets are for a 75-basis-point reduction.

Derivative Distortion

Fed officials lowered their economic-growth estimates to zero to 0.3 percent for 2008, from 1 percent to 1.6 percent previously, the median forecast of Fed governors and district- bank presidents showed. The predictions for GDP next year ranged from a contraction of 0.2 percent to growth of 1.1 percent. The jobless rate is projected to be 7.1 percent to 7.6 percent.

“Bond yields, we feel, are somewhat distorted by what’s happening in the derivatives market,” said Chris Ahrens, an interest-rate strategist at UBS Securities LLC in Greenwich, Connecticut, one of 17 primary dealers that trade with the Fed.

Derivatives contracts tied to the value of the yen have helped drive down 10- and 30-year interest-rate swap spreads as the Japanese currency rallies against the dollar, Ahrens said. The yen has gained 16 percent since September as investors purchase the currency to repay loans made in Japan in order to unwind investments in higher-yielding assets.

The price to exchange, or swap, floating for fixed-rate payments for 30 years fell below the yield on similar maturity Treasuries by the most ever as dealers hedged against risk related to derivatives, Ahrens said. The yield on the 30-year bond was as much as 51 basis points higher than the 30-year swap rate. The swap rate has remained below the long bond’s yield since Nov. 5.

Paulson’s Decision

The gap between 10-year swaps and the 10-year note yield reached as low as 6 basis points, the narrowest since at least 1988, when Bloomberg data began tracking the instruments.

Yields have hit record lows since Treasury Secretary Henry Paulson said on Nov. 12 he would abandon plans to use the Troubled Asset Relief Program to buy mortgage assets from banks. The London interbank offered rate has spiked 11 basis points in the three days after Paulson’s shift. Before Paulson’s announcement Libor, which banks charge each other for three- month loans in dollars had fallen for 23 straight days.

“Changing the terms of the TARP as suddenly as he did undermined investor confidence,” said Richard Schlanger, a bond fund manager in Boston at Pioneer Investments, which oversees $44 billion. “It’s a frightening situation.”

Investors erased more than $33 trillion from global stock markets this year as the U.S., Europe and Japan slipped into recession.

Breakeven Rates

Longer-maturity bonds, which are more sensitive to inflation expectations, rallied on speculation that the economic slump may trigger deflation, or a prolonged decline in prices. Consumer prices plunged 1 percent last month, more than forecast and the most since records began in 1947, a Labor Department report showed yesterday.

The difference in yield between two-year and 10-year notes narrowed a fifth day to 2.05 percentage points.

Breakeven rates, which show the difference in yields between inflation-linked and nominal bonds, suggest traders are betting the U.S. economy may face deflation over the next two years. The two-year U.S. breakeven rate was minus 4.09 percentage points.

“You have the cloak of a declining inflationary environment,” said Tom Tucci, head of U.S. government bond trading in New York at RBC Capital Markets, the investment- banking arm of Canada’s biggest lender. “People are denying it, but we are mirroring the whole Japanese situation and if that’s the case interest rates are going to go a lot lower.”

The difference between the yields on two-year government debt in the U.S. and Japan has narrowed to 44 basis points from 2.33 percentage points at the start of the year. Japanese two- year notes have yielded 0.36 percent on average since 2000.

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net

Last Updated: November 20, 2008 16:50 EST