June 26 (Bloomberg) -- Treasuries headed for their best week in three months on optimism there is sufficient demand to absorb the government’s record bond sales as it raises funds to snap the recession.

Ten-year yields were near a three-week low before the Federal Reserve is scheduled to purchase securities twice next week, while the government pauses in its debt sales. Notes rose the most this month yesterday after a government report showed jobless claims unexpectedly jumped, increasing concern the economic recovery will take time and giving the central bank more reason to keep interest rates low.

“The future auction sizes may be large but there’s also huge demand,” said Yasutoshi Nagai, chief economist in Tokyo at Daiwa Securities SMBC Co., part of Japan’s second-largest brokerage. “I’m bullish on the Treasury market and the trend is for yields to go down.”

The 10-year note yielded 3.55 percent as of 9:28 a.m. in Tokyo, according to BGCantor Market Data. The price of the 3.125 percent security due May 2019 was unchanged at 96 1/2. The yield, which declined to 3.53 percent yesterday, has fallen 24 basis points this week. A basis point is 0.01 percentage point.

Ten-year yields may fall to as low as 3.20 percent over the next two months, Daiwa’s Nagai said. Should his predictions prove accurate, investors who buy the debt today would make a 3.5 percent return, Bloomberg calculations show.

Higher Demand

The Treasury’s sale of two-, five- and seven-year notes this week drew higher demand than forecast supported by indirect bidders, a class of investors that includes foreign central banks. The levels of indirect bidders at this month’s auctions may have been affected by a rule change that eliminated a provision allowing some customer awards to be classified as dealer bids.

The better-than-expected auctions this week helped to “placate fears of a demand shortage for U.S. debt,” Adam Carr, a senior economist at ICAP Australia Ltd. in Sydney, wrote in a research note.

The Treasury’s bond sales will resume with an auction of 10-year Treasury Inflation Protected Securities, or TIPS, on July 6. The Fed, which has bought $180.724 billion in U.S. debt since it began its repurchase program on March 25, is scheduled to buy securities on June 30 and July 1.

‘Very Strong’

“The bottom line is that there was very strong demand,” said James Combias, New York-based head of Treasury trading at Mizuho Securities USA Inc., one of 17 primary dealers required to bid at Treasury auctions. “The supply will continue to be great and you are going to need that type of demand. It’s going to be a challenge for the market going forward.”

Even so, Treasuries are poised for their worst quarter since the first three months of 1980. The securities have lost 3.2 percent since March 31, according to Merrill Lynch & Co.’s U.S. Treasury Master Index.

The U.S. will sell $3.25 trillion of debt in the fiscal year ending Sept. 30, according to primary dealer Goldman Sachs Group Inc. Obama has pushed the nation’s marketable debt to an unprecedented $6.45 trillion. The budget deficit is projected to increase to $1.85 trillion in the year ending Sept. 30, equivalent to 13 percent of the nation’s economy, according to the Congressional Budget Office.

Jobless Claims

Initial jobless claims rose to 627,000 in the week ended June 20 from a revised 612,000 a week earlier, the Labor Department said yesterday. Economists in a Bloomberg News survey had forecast jobless claims would fall to 600,000.

“The fact is that we’re not getting below that 600,000 mark on jobless claims,” said Michael Franzese, head of government bond trading for Standard Chartered in New York. “That means July 2’s jobless number might persist to a 10 percent rate and it’s a psychological thing.”

The jobless rate climbed to 9.6 percent in June, the highest in 26 years, according to the median estimate of economists surveyed by Bloomberg before the July 2 Labor Department report.

The Federal Open Market Committee on June 24 kept interest rates unchanged and said it sees a “gradual resumption of sustainable” growth even as “substantial resource slack” holds down inflation pressures. The benchmark rate will stay at “exceptionally low levels” for an “extended period,” policy makers said.

Rate Bets

Traders added to bets Fed policy makers will keep borrowing costs in the record low range of zero to 0.25 percent this year. Fed funds futures contracts on the Chicago Board of Trade showed a 61 percent chance of rates remaining on hold through this year. The odds have climbed from 48 percent a week ago.

Fed officials also voted to maintain the size and pace of their $1.75 trillion program to buy mortgage debt and Treasuries. The statement indicated policy makers need more time to assess the prospects for a recovery starting in the second half of the year before deciding to embark on any exit from their unprecedented credit programs.

The central bank said yesterday it will let one of its emergency programs expire and trim two others in a sign that improving financial markets allow a first step toward ending its unprecedented interventions.

To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.

Last Updated: June 25, 2009 20:37 EDT