Nov. 10 (Bloomberg) -- Treasury two-year notes, the worst performing U.S. government securities in the past year, may beat longer-term debt as the Federal Reserve cuts interest rates to pull the U.S. economy out of a nosedive, according to one of the bond market's most-watched barometers.

The difference between yields on two- and 10-year notes, known as the yield curve, may widen to a record 3 percentage points from 2.46 percentage points now, according to strategists at Morgan Stanley and Credit Suisse Group AG. Shorter-term yields are falling on expectations the Fed will reduce its target for overnight loans between banks to curtail the recession. Ten-year yields are likely to rise as the government borrows to bail out the U.S. financial system, they said.

Two-year notes returned about 2.3 percentage points more than 10-year securities as the yield curve reached its record of 2.74 percentage points in August 2003 and the Fed finished a series of 13 rate reductions. Historically, the gap is steepest as the central bank stops cutting and investors anticipate an economic recovery, according to Tony Crescenzi, chief bond- market strategist at Miller Tabak & Co. LLC in New York.

``As we get into the teeth of this slowdown toward the end, you will see the yield curve steeply sloped,'' said Francis Mustaro, a money manager in New York at J&W Seligman & Co., which oversees about $15 billion. ``It's classic.''

Crescenzi, author of ``The Strategic Bond Investor,'' wrote that the yield curve ``is the closest thing the bond market has to a crystal ball.''

`More Than Compelling'

Treasuries gained 8 percent the past year as the credit crunch sent the economy toward a recession and investors sought the safety of government debt, according to data compiled by Merrill Lynch & Co. Two-year notes gained 7.47 percent, lagging behind the 8.21 percent return for 10-year debt.

The U.S. economy contracted at a 0.3 percent pace in the third quarter, and economists surveyed by Bloomberg forecast it will shrink 0.8 percent through the end of the year.

Goldman Sachs Group Inc. economists led by Jan Hatzius are even more pessimistic, predicting the economy will shrink at a 3.5 percent annual rate in the fourth quarter and at a 2 percent pace the next, according to a Nov. 7 note to investors.

``The evidence is more than compelling'' that the U.S. is in a recession, said Robert Hall, who heads the National Bureau of Economic Research's panel that dates economic cycles. Hall, an economics professor at Stanford University, spoke Nov. 7 after a government report showed unemployment rose to 6.5 percent in October and job losses stretched into a 10th month.

Obama's Inheritance

It will take at least 18 months to turn around the U.S., even if President-elect Barack Obama ``does everything perfectly,'' Columbia University Professor and Nobel Prize- winning economist Joseph Stiglitz wrote in the Washington Post Nov. 9. Obama vowed on Nov. 7 to confront the faltering economy when he takes office in January, and called on Congress to pass stimulus legislation.

Yields on two-year notes dropped 23 basis points last week to 1.33 percent as the price of the 1.5 percent security due October 2010 rose 14/32, or $4.38 per $1,000 face value, to 100 10/32, according to BGCantor Market Data. The yield on the 4 percent note due August 2018 fell 18 basis points to 3.79 percent.

Two-year rates climbed to 1.37 percent and 10-year yields rose to 3.83 percent as of 8:54 a.m. today in New York.

Best May Be Over

An investor buying $100 million of two-year notes betting on a steeper curve will earn $1.33 million if the gap widens to 3 percentage points, according to data compiled by Bloomberg. The figure is weighted so the value of a basis point move in either note has an equal dollar impact.

Brian Brennan, a portfolio manager who helps oversee $13 billion in fixed income at T. Rowe Price Group Inc. in Baltimore, says the best may be over for shorter-term Treasuries amid signs efforts by central banks around the world to encourage lending are working.

``We are at the tail end of the cycle,'' Brennan said. ``The curve has done what it is supposed to do during a risk- averse environment.''

The London interbank offered rate for three-month dollar loans dropped to 2.29 percent Nov. 7 from this year's high of 4.82 percent on Oct. 10. The gap between what banks and the Treasury pay to borrow for three months, known as the TED spread, shrank to 2.01 percentage points from 4.64 percentage points.

Scarce Credit

Still, credit for companies remains scarce. The TED spread averaged 0.3 percentage point in the five years before the crisis erupted in August 2007. General Motors Corp., the biggest U.S. automaker, said Nov. 7 it may not have enough cash to keep operating this year as it seeks federal aid.

Yields on longer-maturity securities climbed more than short-term notes after the jobs report as traders focused on this week's auctions of $55 billion in new debt, the biggest so- called quarterly refunding since 2004.

The budget deficit may swell 58 percent to $687.5 billion for fiscal 2009 as the government borrows to rescue banks and the slowing economy cuts tax receipts, according to a survey by the Securities Industry and Financial Markets Association of its members released Oct. 31.

Near Zero

Investors expect the Fed to lower its target rate near zero percent for the first time, a level already reached by banks trading in the open market as the Fed pumps capital into the banking system. Excess reserves averaged $282 billion for the two weeks ended Oct. 22, up from $136 billion in the period ended Oct. 8, according to central bank data.

Futures on the Chicago Board of Trade show a 97 percent probability policy makers will reduce rates by a half percentage point to 0.5 percent when they next meet on Dec. 16. The Fed already cut its target rate nine times since September 2007.

Two-year note yields finished last week 1.10 percentage points above the 0.23 percent fed funds' effective rate, a volume-weighted average of trades between major brokers for overnight funds. It reached 1.33 percentage points on Oct. 31, the widest since August 2004. The Fed started paying interest on reserves last month to better manage the funds rate.

``The front end is very attractive in terms of the carry and if nothing else, banks will be attracted to owning it,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of 17 primary dealers that trade bonds with the U.S. central bank. That part of the curve has ``yields well above where they can fund themselves,'' he said.

Mutual fund investors increased their bets on two-year notes this month and set up trades to profit if 10-year note prices fall, according to Morgan Stanley. Interest-rate strategists at the New York-based firm looked at the change in funds' net asset value compared with the benchmark index.

``The Fed is an easing mode, the economy is continuing to weaken, central banks are lowering rates, and new supply is coming,'' said Theodore Ake, head of Treasury trading in New York at Mizuho Securities USA Inc., another primary dealer. ``That continues to bode for a steeper yield curve.''

To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Liz Capo McCormick in New York at emccormick7@bloomberg.net.

Last Updated: November 10, 2008 09:02 EST