By Cordell Eddings March 27 (Bloomberg) -- Treasuries fell, pushing 10-year note yields up the most since December, as lower-than-average demand at $118 billion in note auctions raised concern that investor interest is waning as the deficit climbs to a record. U.S. interest-rate swap spreads plunged to the lowest levels in more than two decades as investor focus shifted from the plight of financial institutions to the ability of nations to finance rising fiscal deficits. Bill Gross, manager of the world’s biggest bond fund, said the almost three-decade bond rally may be ending. Two-year notes dropped for a fourth week in the longest stretch of decreases since August before next week’s March payrolls report. “Supply and the realization that there is more to come is starting to weigh on Treasuries,” said Larry Milstein, managing director of government and agency debt trading in New York at R.W. Pressprich & Co., a fixed-income broker and dealer for institutional investors. “Swap spreads turning negative forced investors to cover shorts and dump Treasuries going into the auction, exacerbating the weakness.” A short is a bet that a security will decrease. The 10-year note’s yield rose 15 basis points, or 0.15 percentage point, to 3.85 percent, according to BGCantor Market Data. The price of the 3.625 percent note due in February 2020 decreased 1 7/32, or $12.19 per $1,000 face amount, to 98 5/32. The increase in the yield was the biggest since an advance of 27 basis points for the week that ended Dec. 25. The yield touched 3.92 percent on March 25, the highest level since June 11. The two-year note’s yield rose 5 basis points to 1.04 percent and reached 1.12 percent this week, the highest level since Jan. 4. Auction Demand Demand waned at this week’s auctions of two-, five- and seven-year notes as signs of improvement in the economy boosted appetite for higher-yielding assets. At the $32 billion seven-year note sale on March 25, investors bid for 2.61 times the amount of debt on offer, the least in 10 months. The $42 billion auction of five-year debt a day earlier drew a yield of 2.605 percent, compared with the average forecast of 2.556 percent in a survey of eight of the Fed’s 18 primary dealers. The difference of 4.9 basis points was the largest since July, based on Bloomberg surveys. Investors bid for 3 times the $44 billion of two-year notes sold on March 23, the lowest since December’s sale. President Barack Obama has increased U.S. marketable debt to a record $7.4 trillion as he borrows to sustain the U.S, economic expansion. Gross on Borrowing Excess borrowing in nations including the U.S., U.K. and Japan will eventually lead to inflation as governments sell record amounts of debt to finance surging deficits, Gross said in an interview this week with Tom Keene on Bloomberg Radio from the headquarters of Pacific Investment Management Co. in Newport Beach, California. Pimco, which announced in December that it would offer stock funds, is advising that investors buy the debt of countries such as Germany and Canada that have low deficits and higher-yielding corporate securities. Treasuries have lost 1.3 percent this month, paring their first-quarter returns to 0.7 percent, according to Bank of America Merrill Lynch indexes. Former Federal Reserve Chairman Alan Greenspan said in a Bloomberg Television interview yesterday that the recent increase in yields represents a “canary in the mine” reflecting investor concern over the U.S. budget deficit Economic Expansion The world’s largest economy expanded at a 5.6 percent annual rate in the fourth quarter of 2009, figures from the Commerce Department showed yesterday. The increase, while smaller than the government’s previous estimate issued last month, marked the best performance in six years. Employers added 190,000 jobs this month after eliminating 36,000 positions in February, according to the median forecast of 62 economists in a Bloomberg News survey. The unemployment rate held at 9.7 percent. The Labor Department’s payrolls report is due on April 2. The 10-year swap spread, or the difference between the rate to exchange the payment streams and the Treasury yield, turned negative for the first time on March 23. The gap dropped as low as negative 10.19 basis points this week. A negative swap spread means the Treasury yield is higher than the swap rate, which typically is greater given that the floating payments are based on interest rates that contain credit risk, such as the London interbank offered rate. “Rates have been unsettled for the past few days since swap spreads started going negative,” said Aaron Kohli, an interest-rate strategist in Stamford, Connecticut, at Royal Bank of Scotland Group Plc, a primary dealer. “Since then, we’ve seen lots of instability in the market, which continues to make investors nervous.” To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

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