By Sandra Hernandez and Bo Nielsen Oct. 10 (Bloomberg) -- Treasuries fell on speculation the U.S. government will sell more debt to finance a rescue of the financial system as stocks fell worldwide and credit markets remained frozen. The declines pushed 10-year notes to the biggest weekly drop since June as speculation mounted that the Treasury will take ownership stakes in a wide range of banks. The government sold $40 billion in extra notes in the past two weeks as the worst financial crisis since the Great Depression sapped demand for all but the safest assets. ``Supply is going to dominate the Treasury price action,'' said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world's largest inter-dealer broker. ``Rates are going to go higher. They have to.'' The yield on two-year notes gained 7 basis points, or 0.07 percentage point, to 1.60 percent at 8:54 a.m. in New York, according to BGCantor Market Data. The 2 percent security due September 2010 slipped 5/32, or $1.56 per $1,000 face amount, to 100 25/32. The yield on the 10-year note rose 7 basis points to 3.85 percent. It's up 25 basis points since the end of last week, the biggest five-day increase in four months. The Federal Reserve said this week it will begin buying commercial paper, the short-term loans companies used to conduct day-to-day business, further increasing costs. The Treasury Department also plans to buy stakes in banks within weeks, two officials informed of the matter said yesterday. `Supply Side' Yields on three-month Treasury bills, viewed as a haven in times of turmoil, fell 16 basis points to 0.36 percent, compared with 3.25 percent at the start of the year. Standard & Poor's 500 Index futures tumbled 3.2 percent. The MSCI World lost 3.7 percent, extending this week's drop to 19 percent, the most since records began in 1970. ``We have seen some kind of decoupling between Treasuries and the stock market this week,'' said Karsten Linowsky, a fixed-income strategist in Zurich at Credit Suisse Group. ``Treasuries aren't benefiting so much anymore from the increasing risk aversion. People have started to worry about how much these rescue packages will influence the supply side.'' The U.S. yesterday auctioned $20 billion in notes in the second round of special sales to relieve shortages, plus $30 billion of 97-day bills. The government is scheduled to sell two-and five-year notes and five-year Treasury Inflation Protected Securities in regularly scheduled auctions at the end of the month. It will announce upcoming borrowing needs in its quarterly refunding announcement on Nov. 5. Bets on Fed Treasury Inflation Protected Securities, or TIPS, indicate traders expect inflation to slow. TIPS maturing in 10 years yielded 0.98 percentage points less than conventional notes, the least since 1999. The gap between the securities' yields reflects the average inflation rate traders expect over the next 10 years. Prices of goods imported into the U.S. fell in September the most since April 2003 on lower energy costs, easing inflation pressures as the economy weakens, the Labor Department said today in Washington. They dropped 3 percent, more than forecast, after declining a revised 2.6 percent in August. Ten central banks including the Federal Reserve cut interest rates in the past two days in a bid to revive bank lending and restore confidence in financial markets. Traders are betting the Fed will cut interest rates for a second time this month. Futures contracts on the Chicago Board of Trade show a 100 percent chance the Fed will reduce its 1.5 percent target rate for overnight lending between banks by at least a quarter-percentage point at its meeting on Oct. 29. `Special Times' Two-year notes, the most sensitive to monetary policy, gained earlier this week after the U.S. passed a $700 billion rescue package for finance companies and Germany, the U.K., Luxembourg and Iceland rescued banks that fell victim to the worsening credit squeeze. ``These are special times,'' said Stuart Thomson, who helps manage $46 billion in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. ``The markets are completely broken. The Fed will cut rates to 0.5 percent, so two-year Treasuries can yield 0.75 percent next year.'' Government and central bank actions have yet to thaw the year-long freeze in money markets as banks hoard cash. The difference between what banks and the Treasury pay to borrow for three months, the so-called TED spread, widened to 4.42 percentage points, the most since Bloomberg began compiling the data in 1984, from 1.18 percentage points a month ago. The Securities Industry and Financial Markets Association recommended a 2 p.m. market close today and a full close on Oct. 13 for the U.S. Columbus Day holiday. To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net

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