(Bloomberg) — Treasuries rallied, driving two-year note yields to a another record low and sending those on 10-year securities below 2.5 percent for the first time since March 2009 after an industry report showing sales of existing homes tumbled in July bolstered concern the economy is faltering.

The difference between the two-year note yield and the Federal Reserve’s target lending rate fell to the narrowest level since December 2008, when the central bank adopted a range of zero to 0.25 percent. The government prepared for a $37 billion auction of two-year notes a day after the sale of 30-year inflation-indexed bonds drew record demand.

“Fear is driving the Treasury market right now to lower rates,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo & Co. in Milwaukee. “This is the kind of thing that may reinforce the idea of a double-dip recession.”

The yield on the 10-year note fell 7 basis points, or 0.07 percentage point, to 2.53 percent at 12:46 p.m. in New York, according to BGCantor Market Data. The price of the 2.625 percent security maturing in August 2020 rose 5/8, or $6.25 per $1,000 face amount, to 100 27/32.

The benchmark 10-year note’s yield earlier slid to 2.4668 percent, a 17-month low. The two-year note yield dropped less than 1 basis point to 0.48 percent after touching a record low 0.4542 percent.

The extra yield investors demand to hold 30-year bonds over two-year notes narrowed to about 3.14 percentage points, the lowest since October 2009, on concern the recovery is stalling. The difference between the two-year note yield and the one-month bill rate was the narrowest since April 2008.

European Bonds

European bonds gained in tandem with Treasuries, with the German 10-year yield dropping to a record low. The Standard & Poor’s 500 Index fell 1.1 percent. Credit-default swaps rose to a seven-week high. The dollar fell as much as 1.8 percent to 83.60 yen, the lowest since June 1995. Crude oil for October declined 1.5 percent to $72 a barrel.

“The housing data was ugly and extremely weak, which is clearly a concern given the fragile state of the economy,” said Larry Milstein, managing director of government and agency debt trading in New York at R.W. Pressprich & Co., a fixed-income broker and dealer for institutional investors. “The concern now is that the Fed might need to do more than reinvest interest income and proceeds from maturing bonds.”

Fed Policy

In an attempt to bolster the economy, policy makers said on Aug. 10 that the central bank would maintain its holdings of securities at $2.05 trillion to prevent money from draining out of the financial system. Fed Chairman Ben S. Bernanke will discuss the outlook for the economy on Aug. 27 at a conference in Jackson Hole, Wyoming.

The U.S. economy grew at 1.4 percent annual pace in the second quarter, which would be the slowest rate since the recovery began in the middle of last year, a Commerce Department update on Aug. 27 is forecast by analysts to show. A 2.4 percent pace was calculated last month.

The Fed will probably ease monetary policy further as the U.S. economy weakens, said Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, in a radio interview on “Bloomberg Surveillance” with Tom Keene. Hatzius predicts the economy will expand at a 1.5 percent annual pace in the second half of the year and unemployment will rise to 10 percent next year from 9.5 percent currently.

Two-Year Auction

Before today’s two-year note sale, the securities yielded 0.492 percent in pre-auction trading, compared with the record low of 0.665 percent at the previous offering on July 27. Investors bid for 3.33 times the amount on offer last month, compared with an average of 3.19 for the past 10 sales.

“With the Fed remaining on hold apparently until the end of 2011 at the earliest, shorter-term Treasuries are increasingly being thought of as cash by clients,” Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York, wrote in a note to clients. “There is nothing in pre- auction trading nor on the macro front to suggest the results of today’s auction will go any better/worse than recent auctions.”

Yesterday’s sale of 30-year Treasury Inflation Protected Securities, or TIPS, drew a yield of 1.768 percent, the lowest ever for sales of the debt dating to 1998. The bid-to-cover ratio, which gauges demand by comparing total bids with the amount of bonds offered, was a record high 2.78.

Note Auctions

The Treasury is also scheduled to auction $36 billion of five-year debt tomorrow and $29 billion in seven-year securities the following day. Altogether, the $102 billion of notes being sold this week is the smallest total for this combination of securities since May 2009.

The Fed will purchase about $18 billion of U.S. debt by the middle of September using the money from principal payments on its holdings of agency debt and agency mortgage-backed securities. The central bank bought $1.35 billion of Treasuries today, increasing the total since the central bank began the program on Aug. 17 to $7.51 billion.

–Editors: Dennis Fitzgerald

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

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