By Sandra Hernandez and Lukanyo Mnyanda Oct. 17 (Bloomberg) -- Treasury notes rose before a government report economists say will show the U.S. housing slump deepened last month, strengthening the case for lower interest rates to boost the economy. Ten-year notes pared a weekly loss after former Federal Reserve Vice Chairman Alan Blinder said the U.S. is at the start of a ``serious'' recession. Two-year debt headed for a weekly gain as traders added to bets the Fed will cut interest rates for a second time this month at its Oct. 29 meeting. ``The economic news is going to continue to be really weak,'' said Tom Tucci, head of U.S. government bond trading in New York at RBC Capital Markets, the investment-banking arm of Canada's biggest lender. ``The biggest trade will be whether or not the Fed eases at the end of this month.'' The yield on the 10-year note fell 2 basis points to 3.94 percent as of 8:11 a.m. in New York, for a weekly gain of 7 basis points, according to BGCantor Market Data. The 4 percent security maturing August 2018 climbed 6/32, or $1.88 per $1,000 face amount, to 100 15/32. Yields on two-year notes fell 2 basis points to 1.61 percent. Housing starts fell 2.6 percent last month to an annual rate of 872,000, according to the median forecast in a Bloomberg News survey of 74 economists. The Commerce Department releases the report at 8:30 a.m. in Washington. A University of Michigan survey may show consumer sentiment fell in October for the first time in four months, a separate Bloomberg poll showed. Bank Losses ``We're returning to normality in the sense that the economic data does matter,'' said Marius Daheim, a senior bond strategist in Munich at Bayerische Landesbank, Germany's second- biggest state-owned bank. ``There's more to come in terms of interest-rate cuts from the Fed.'' Investors should favor shorter-dated notes, as the Fed will likely cut interest rates another 50 basis points this month, Daheim said. The U.S. housing recession increased defaults on subprime mortgages and led to a freezing of credit markets globally, swelling losses and writedowns at banks and securities companies to $660 billion since the start of 2007, according to data compiled by Bloomberg. ``We're in the early stages of a bad, old-fashioned recession, where consumers stop spending and therefore businesses stop hiring workers,'' Blinder said yesterday on Bloomberg Radio. ``It looks quite serious.'' U.S. industrial production fell 2.8 percent in September, the most since 1974, the Fed said yesterday. Retail sales dropped 1.2 percent last month, extending the decline to three straight months, the longest slump in at least 16 years, Commerce Department figures showed Oct. 15. The U.S. economy will shrink 0.3 percent in the fourth quarter, according to a Bloomberg survey of analysts. Inflation Expectations Traders' expectations for inflation over the next decade have fallen to the lowest level in almost 10 years as the price of oil plunged by more than half from a record $147.27 a barrel in July. The difference between rates on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes was 0.95 percentage points. Crude on the New York Mercantile Exchange traded at $70.69 a barrel today. Futures on the Chicago Board of Trade show a 50 percent chance the Fed will cut its target rate for overnight bank loans by a half-percentage point to 1 percent at the end of the month. The odds were 28 percent a week ago. The rest of the bets are for a quarter-point reduction. Bank Bailouts U.S. plans to invest in banks and other ``powerful'' efforts to unblock credit markets should revive economic growth next year, Fed Bank of Boston President Eric Rosengren said yesterday. He doesn't vote on monetary policy this year. Fed Chairman Ben S. Bernanke and Vice Chairman Donald Kohn said this week the economy will not recover quickly. Demand for some of the safest assets waned after Treasury Secretary Henry Paulson pledged to buy $250 billion of shares in the U.S.'s biggest banks. The difference in yield between two- and 10-year Treasuries narrowed to 2.34 percentage points from 2.39 percentage points on Oct. 15, the most since 2004. Treasuries returned 2.3 percent since the end of June, according to the Treasury Master Index compiled by Merrill Lynch & Co. European bonds earned 4.9 percent, its EMU Direct index showed. Gains by Treasuries may be limited as money markets show signs of thawing after the U.S. and other nations agreed to spend almost $3 trillion to rescue banks imperiled by the credit crisis. Bank Lending The London Interbank Offered Rate, or Libor, for borrowing in dollars overnight fell for a sixth day, slipping 27 basis points, to 1.67 percent. That's the lowest level since September 2004. The Libor-OIS spread, a measure of the scarcity of cash, eased for a third day, narrowing 32 basis points in the week to 3.32 percentage points. The spread was 24 basis points on Jan. 24. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, was at 3.96 percentage points from 4.63 percentage points at the end of last week. ``There's a bit of a lull in the market, with money markets calming down a bit,'' said Orlando Green, a fixed-income strategist in London at Calyon, the investment-banking unit of France's Credit Agricole SA. ``But the market's going to remain nervous, and it's hard to see bonds selling off in a sustained manner.'' To contact the reporters on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net; Lukanyo Mnyanda in London at lmnyanda@bloomberg.net.

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