By Dakin Campbell and Bo Nielsen Oct. 29 (Bloomberg) -- Treasuries gained for the first time in three days, led by two-year notes, on speculation the Federal Reserve will cut its key interest rate by a half-percentage point today to 1 percent. U.S. government securities headed for a fifth monthly gain. Two-year note yields were 10 basis points above the Fed's target rate for overnight loans, compared with the 17-point average in the last three months, after the U.S. sold $34 billion of the notes yesterday at better-than-average demand. ``The two-year has been a reflection of the Fed easing,'' said Lawrence Dyer, an interest-rate strategist in New York at HSBC Securities USA Inc., one of the 17 primary dealers that trade with the U.S. central bank. ``Unless there is some additional dramatic action, I'd look at two-years as staying in a volatile trading range reflecting illiquidity and the potential the Fed would ease lower.'' Two-year yields fell 5 basis points, or 0.05 percentage point, to 1.60 percent at 10:36 a.m. in New York, according to BGCantor Market Data. The 1.5 percent security maturing in October 2010 increased 3/32, or 94 cents per $1,000 face amount, to 99 25/32. Ten-year yields were little changed at 3.85 percent. `Looking for a Rate Cut' ``People are looking for a rate cut by the Fed, and that's fueling Treasury buying,'' said David Keeble, head of fixed- income strategy in London at Calyon, the investment-banking arm of Credit Agricole SA. Futures on the Chicago Board of Trade show a 100 percent probability the central bank will trim its target rate for overnight bank loans by at least a half-percentage point from 1.5 percent. The odds increased from no chance a month ago. While central bankers usually pay close attention to futures when deciding interest rates, the actual rate banks charge each other for overnight loans has not followed the Fed's target rate. That suggests it may be hard to gauge the market response to today's action. The central bank will lower the benchmark interest rate below 1 percent by the end of the first quarter next year, according to 7 of 57 economists and strategists polled by Bloomberg News. Two-year yields have averaged 23 basis points above the federal funds target rate over the past decade, according to Bloomberg data. ``We continue to look for the U.S. two-year to head for the sub-1 percent area,'' Padhraic Garvey, the Amsterdam-based head of interest-rate strategy for ING Bank NV, wrote in a note today. `It All Depends' The difference in yield, or spread, between two-year notes and 10-year securities grew to 2.23 percentage points, showing the so-called yield curve has steepened as traders favor shorter-maturity debt. The spread was 2.07 percentage points on Oct. 23. ``Whether we flatten or steepen, it all depends on where do we think this market is going'' after today's announcement, said Michael Franzese, head of government-bond trading for Standard Chartered in New York. ``Is the front end finally going to get its comeuppance, so to speak, and are people starting to realize we are not in such dire straits?'' The Fed cut its key interest rate by half a percentage point on Oct. 8 in a coordinated effort with other major central banks to quell financial turmoil and avert a recession. It has slashed the rate from 5.25 percent since September 2007 as the crisis in credit markets intensified. Durable Goods Orders for U.S. durable goods excluding transportation equipment fell in September for a second month, by 1.1 percent, the Commerce Department said in Washington. A rebound in aircraft orders, a volatile category, and an increase in defense bookings unexpectedly pushed total orders up 0.8 percent. The U.S. economy probably shrank in the third quarter for the second time in a year, contracting at a 0.5 percent annual rate, the most since the 2001 recession, according to economists surveyed by Bloomberg. Commerce Department figures on gross domestic product are due tomorrow. Yields indicate banks are less willing to lend than earlier in 2008. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened to 2.78 percentage points, from this year's low of 0.76 percentage point in May. The figure was 4.64 percentage points on Oct. 10, the most since Bloomberg data began in 1984. Treasury Supply The U.S. sold $34 billion of two-year notes yesterday, matching a record, drawing yields of 1.60 percent, the lowest since March 2004. It plans to sell $24 billion five-year securities tomorrow. It will announce on Nov. 5 how it plans to boost its debt sales later in the month. Ten-year securities fell the most in two weeks yesterday after Anthony Ryan, acting Treasury undersecretary for domestic finance, said the U.S. may sell more long-term debt to address ``unprecedented'' needs to finance a growing budget deficit and a rescue of the financial system. Former Fed Governor Frederic Mishkin said yesterday the market shock is ``more pervasive'' than during the Great Depression. Treasuries returned 0.5 percent in October, according to Merrill Lynch & Co.'s U.S. Treasury Master index. To contact the reporters on this story: Dakin Campbell in New York at dcampbell27@bloomberg.net; Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net

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