By Dakin Campbell and Lukanyo Mnyanda Oct. 21 (Bloomberg) -- Treasury notes rose as investors increased bets the Federal Reserve will cut interest rates next week to revive the economy and regional banks' third-quarter profits fell, boosting demand for the safest assets. Two-year notes, the most sensitive to changes in monetary policy, outperformed longer-dated debt. The odds the U.S. central bank will lower its target rate by a half-percentage point next week rose to 68 percent, from 42 percent yesterday, according to futures on the Chicago Board of Trade. Profits fell at National City Corp., Fifth Third Bancorp., Regions Financial and Keycorp. ``It's conceivable that the Fed funds rate could get to 1 percent again,'' said Tom di Galoma, head of U.S. Treasury trading at Jefferies & Co., a brokerage for institutional investors in New York. ``This past winter and spring when Fed speakers were worried about inflation, I was more worried about the economy. I continue to be.'' The yield on the two-year note tumbled 12 basis points, or 0.12 percentage point, to 1.60 percent at 9:31 a.m. in New York, according to BG Cantor Market Data. The 2 percent security due September 2010 advanced 7/32, or $2.19 per $1,000 face amount, to 100 24/32. The 10-year note's yield fell 9 basis points to 3.78 percent. Investors should buy six-month or one-year Treasury bills and sell two-year notes, di Galoma said. Rates on three-month bills, viewed as among the safest securities because of their short maturities, advanced 13 basis points to 1.21 percent. They increased 61 basis points last week. Six-month bill rates rose 1 basis point to 1.62 percent. Stock Futures Government securities also gained as U.S. stocks fell, with the Standard & Poor's 500 Index retreating 1.7 percent. S&P 500 Index futures earlier declined after Texas Instruments Inc., the second-largest U.S. semiconductor maker, predicted earnings that trailed analysts' estimates and Sun Microsystems Inc. said sales fell short of estimates. `` Treasuries are not an area that I think are stupid cheap. Will you get your principal back: that may be the most important thing of all,'' said David Ader, head of U.S. government bond strategy in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 17 primary dealers that trade with the Fed. ``It may not be about yield but simply return of principal, which may explain why Treasuries remain quite firm in here.'' Two-year notes yielded 2.18 percentage points less than 10- year notes, compared with 2.14 percentage points yesterday. The spread widened for the first time since Oct. 15 as investors favored the safest assets. The gap was at 2.39 percentage points on Oct. 15, the biggest difference since February 2004. `Open to the Idea' Fed Chairman Ben S. Bernanke told the House Budget Committee yesterday the danger of a ``protracted slowdown'' and a ``weak'' outlook for the U.S. economy into next year convinced him to support a new round of economic stimulus. A similar endorsement by Bernanke earlier this year helped clear the way for a $168 billion measure enacted in February. The Bush administration is ``open to the idea'' of more measures to stimulate the economy, though approval would depend on details drafted by Congress, Press Secretary Dana Perino said yesterday. Volatility Down A measure of price swings in the Treasury market fell to an almost one-month low. Merrill Lynch's MOVE Index, which measures volatility in Treasuries, fell to 191.6 yesterday, the lowest since Sept. 26. The index climbed to 264 on Oct. 10, the most since the data began 20 years ago. It has averaged 138 for the past year. ``Things have slowed down in terms of volatility,'' said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world's largest inter-dealer broker. Markets are ``feeling better about the possibility of a stimulus package.'' Still, the economy ``is not out of the woods'' and the two- year Treasury yield may drop to 1.5 percent before the end of the year as investors bet on more rate cuts, said Allan von Mehren, a Copenhagen-based fixed-income strategist at Danske Bank AS, the biggest lender in Denmark. Governments and central banks in the world's biggest economies have cut borrowing costs, increased funds in the banking system and purchased bank shares to ease a credit freeze that triggered the biggest swings on financial markets since the 1987 stock-market crash. Banks' reluctance to lend eased as the difference between what they and the Treasury pay to borrow money for three months, the so-called TED spread, fell for an eighth day. It declined to 2.61 percentage points today, from 4.64 percentage points on Oct. 10, the most since at least 1984 when Bloomberg started compiling the data. The London interbank offered rate, or Libor, that banks charge each other for overnight loans in dollars dropped 23 basis points to 1.28 percent. It's the first time the rate has slid below the Fed's benchmark rate since Oct. 3. The Treasury is scheduled to sell $27 billion of four-week debt and $20 billion of one-year securities today. To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Lukanyo Mnyanda in London at lmnyanda@bloomberg.net

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