Jan. 8 (Bloomberg) -- Goldman Sachs Group Inc. said the U.S. Treasury market hasn’t turned into an asset bubble even as investors debate the wisdom of buying government bonds with yields near record lows.

The U.S. economy is likely to expand below its potential for the next six to eight quarters, resulting in lower “core” inflation, according to a report released today by the New York- based firm. Inflation erodes the fixed payments of bonds.

“By mapping one-year ahead macro expectations to long- dated government yields through our Sudoku framework we find that global bonds are, in the aggregate, currently trading close to the model’s measure of ‘fair value,’” Francesco Garzarelli, chief interest-rate strategist at Goldman Sachs in London, wrote in an e-mailed research note.

As the year progresses and investors’ focus shifts to the prospects for recovery into 2010, yields will likely drift higher, though in line with Goldman Sachs’ forecasts, Gazarelli wrote. Treasury 10-year note yields will likely trade at 3 percent to 3.25 percent by year-end, he said. During the current quarter, yields will trade in a 2.50 to 2.75 percent range, Goldman Sachs’ predicts.

Yields on 10-year notes dropped three basis points today to 2.46 percent. They’ve climbed about 43 basis points since hitting a record low of 2.035 percent on Dec. 18.

Zero Interest Rates

Investors piled into government debt last year to flee riskier assets as the U.S. economy entered its first recession since 2001, while losses and writedowns at financial companies worldwide rose to $1 trillion, according to data compiled by Bloomberg. Treasuries returned 14 percent, indexes compiled by New York-based Merrill Lynch & Co. show.

Government bonds last year outperformed the Standard & Poor’s 500 Index by 53 percentage points, the widest margin since Merrill Lynch started calculating fixed-income returns in 1978.

The surge in demand for the relative safety of U.S. government debt last year caused rates on three-month Treasury bills to turn negative on Dec. 9 for the first time. The same day, the U.S. sold $30 billion of four-week bills at a zero percent rate. The Federal Reserve cut its main lending rate to between zero and 0.25 percent on Dec. 16.

“As U.S. policy rates have fallen to their zero nominal bound, the long-end of the government bond curve has itself become a ‘policy tool’” with the Fed now evaluating benefits of direct purchases of Treasuries, Garzarelli wrote.

Market Forecasts

The majority of Wall Street’s biggest bond firms predict Treasuries will fall this year for the first time in a decade as efforts to spur the economy gain traction and the flight to safety that drove the best returns in government debt since 1995 wanes.

Benchmark 10-year notes may lose 3.5 percent this year, the first loss since declining 8.3 percent in 1999, based on the median forecast of the 17 primary government security dealers that trade with the Fed. After last year’s rally, yields are so low coupon payments can’t make up for any drop in bond prices, they said.

“With headline CPI inflation forecast to fall into negative territory in the months ahead, uncertainties over when private lending will recover and the Fed committed to using its balance sheet more aggressively, the risks remain skewed towards lower yields relative to our baseline projections,” Gazarelli wrote in the note.

Consumer prices tumbled the most on record in November, and builders broke ground on the fewest new homes in at least half a century, as a deepening economic contraction raised the risk of deflation. The cost of living dropped 1.7 percent in November.

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net

Last Updated: January 8, 2009 10:11 EST