By Wes Goodman Nov. 19 (Bloomberg) -- Treasuries rose, and yields showed inflation expectations are the lowest in at least a decade, before a government report that economists say will show consumer prices fell the most since 1949. Two-year yields dropped to levels not seen since 2003 as traders added to bets for the Federal Reserve to cut interest rates to spur the shrinking U.S. economy. Treasury Secretary Henry Paulson yesterday cautioned against trying to use the government's financial-rescue program as an economic recovery package, saying it was designed to stabilize financial markets. ``The rally has gone beyond my expectations,'' said Takashi Yamamoto, chief trader in Singapore at Mitsubishi UFJ Trust & Banking Corp., part of Japan's largest bank. ``Inflation risk is declining. Yields may go down a bit more.'' The benchmark 10-year yield fell three basis points to 3.49 percent as of 6:01 a.m. in London according to BGCantor Market Data. The price of the 3.75 percent security maturing in November 2018 increased 9/32, or $2.81 per 1,000 face amount, to 102 5/32, gaining for a fourth day. Yields on two-year notes, among the most sensitive to changes in borrowing costs because of their short maturities, fell one basis point to 1.12 percent. They will decline to a record 1 percent by year-end, Nagai said. The rate slid to 1.0558 percent on June 13, 2003, the lowest since the Fed began tracking it in 1976. Inflation Expectations The difference between rates on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes, which reflects the outlook among traders for consumer prices, was 55 basis points. The spread yesterday shrank to the narrowest since Bloomberg began compiling the figures in 1998. Futures on the Chicago Board of Trade show an 88 percent chance the central bank will reduce its target for overnight bank loans, now 1 percent, by 50 basis points at its next meeting on Dec. 16. The odds of a 75-basis-point cut rose to 12 percent as of late yesterday in New York from zero a day before. A basis point is 0.01 percentage point. Barack Obama will take office in January during a global recession that has led investors to shun all but the safest assets. The U.S. economy will contract 2.05 percent in the fourth quarter and 0.9 percent in the first three months of 2009, according to a Bloomberg News survey of economists. Paulson rejected using the $700 billion rescue program as a ``panacea'' for economic troubles, in comments yesterday before a congressional panel, resisting pressure from lawmakers to head off housing foreclosures. Annual Return Treasuries returned 7.4 percent so far this year, while German government bonds rallied 8.1 percent and Japanese sovereign securities gained 1.4 percent, according to indexes complied by Merrill Lynch & Co. U.S. corporate bonds handed investors a 15 percent loss, heading for their worst year since Merrill started compiling the figures in 1997. McDonald's Corp., the world's largest restaurant company, plans to increase investment in Asia in 2009 to boost customer numbers as a global recession forces people to reduce their living expenses. ``People are trading down and we're capitalizing on that,'' Tim Fenton, McDonald's president for Asia, the Middle East and Africa, said yesterday in a Bloomberg Television interview. U.S. consumer prices probably dropped 0.8 percent last month, the most since 1949, after being unchanged in September, according to the median estimate in a Bloomberg News survey before the Labor Department reports the figure today. Discounts Target Corp., the second-largest U.S. discount chain, said it plans to offer larger discounts to draw shoppers. Housing starts dropped to a 780,000 annual pace in October, the lowest level since records began in 1959, economists said before a separate report from the Commerce Department today. Government efforts to boost the economy will also spur U.S. inflation, John Cavalieri and Bob Greer at Pacific Investment Management Co. wrote on the company's Web site. ``This calls for increasing exposure to real assets, notably commodities and inflation-linked bonds,'' the report said. Pimco's Real Return Fund fell 7.5 percent so far this year, beating 54 of its peers, according to data compiled by Bloomberg. Pimco, in Newport Beach, California, also runs the Total Return Fund, the world's biggest bond fund. Yields indicate banks are less willing to lend than earlier in the year. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened to 2.11 percentage points from 2008's low of 76 basis points set in May. Risk Aversion The cost of protecting Japanese corporate bonds from default climbed, according to traders of credit-default swaps. helping erode demand for higher-yielding assets. The Markit iTraxx Japan index rose 19 basis points to 2.90 percentage points, according to Credit Suisse Group AG. ``The move in Treasuries is a pure flight-to-quality move,'' Kevin Flanagan, a fixed-income strategist at Morgan Stanley Global Wealth Management Group in Purchase, New York, said yesterday. ``Risk aversion is so deep that you get back to this trade where the market is saying, `If it's not Treasuries, then I don't want it.''' Morgan Stanley was the second-biggest U.S. securities firm before converting to a bank in September. To contact the reporter on this story: Wes Goodman in Singapore at wgoodman@bloomberg.net.

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