By Matthew Brown and Wes Goodman June 1 (Bloomberg) -- U.S. 10-year Treasuries rose for a second day, extending a two-month rally, as the euro and stocks fell amid concern that bad loans at European banks and measures to cut government deficits will drag on growth. Two-year note yields reached their lowest in a week after the European Central Bank warned yesterday of more bank losses as the debt crisis spreads. Spain, which has the euro area’s third-largest budget deficit, had its credit grade lowered by Fitch Ratings on May 28. China’s manufacturing expanded at a slower pace than estimated in May, sending the MSCI World Index lower for a third day. Treasury markets were closed yesterday for a public holiday. “Treasuries are rallying because risk aversion remains elevated,” said Patrick Jacq, a senior fixed-income strategist at BNP Paribas SA in Paris. “With the market closed yesterday, comments from ECB and the Spanish downgrade are still being digested today.” Benchmark 10-year yields fell five basis points to 3.25 percent as of 7 a.m. in New York, according to BGCantor Market Data. The 3.5 percent security due in May 2020 rose 13/32, or $4.06 per $1,000 face amount, to 102 1/8. The two-year yield fell two basis points to 0.75 percent, after dropping earlier to 0.73 percent. The Stoxx Europe 600 Index fell as much as 2.1 percent, its biggest drop in a week, and the MSCI World Index slid 0.9 percent. The euro fell as much as 1.6 percent to $1.2111. Risk Appetite China’s Purchasing Managers’ Index dropped to 53.9 from 55.7 in April, the Federation of Logistics and Purchasing said in an e-mailed statement today, less than the median 54.5 estimate in a Bloomberg News survey of 18 economists. A separate index released by HSBC Holdings Plc and Markit Economics fell to 52.7, the lowest level in a year. Europe’s debt crisis, which led to speculation the 16- nation euro may break apart, has boosted demand for safety of U.S. government securities. The 10-year yield dropped from 4.01 on April 5 to 3.06 percent on May 25, a drop of almost 1 percentage point. European officials last month announced a loan package worth almost $1 trillion and a program of bond purchases to defend their currency. The euro slid 7.4 percent in May, the most in a month since January 2009. The euro weakened against the dollar and the yen today on concern Europe’s efforts to reduce budget deficits will derail the region’s recovery. Spain and Italy announced additional budget cuts last week. European unemployment unexpectedly rose in April, reaching a 12-year high. The jobless rate in the 16-nation euro area increased to 10.1 percent from 10 percent in March, the European Union’s statistics office in Luxembourg said today. Economists had forecast that the rate would remain unchanged in April, according to a Bloomberg survey. Weaker Euro “There are some complications in the euro area which have stopped us from jumping in until the euro gets closer to what we see as a fair value,” said Gareth Fielding, chief investment strategist at Zug, Switzerland-based Quantum Global Wealth Management, which oversees $2.5 billion for sovereign-wealth funds and central banks. The turmoil in Europe helped Treasuries return 1.7 percent last month, the most since March 2009, according to Bank of America Merrill Lynch indexes. Japanese bonds returned 0.3 percent, while German bunds and U.K. gilts both handed investors 2.4 percent, the indexes show. While Europe’s debt crisis weighs on economic growth, the U.S. recovery may be gaining traction. The Institute for Supply Management’s factory index will show U.S. manufacturing expanded for a 10th month, analysts said before the report today. Investors became more bearish on the outlook for Treasuries through the middle of the year, according to a weekly survey by Ried Thunberg ICAP Inc. Sentiment Index The company’s sentiment index fell to 45 for the seven days ended May 28 from 47 the week before. A figure of less than 50 shows investors expect prices to fall, based on the Jersey City, New Jersey, company’s survey. The 10-year yield advanced to 3.36 percent on May 27, the most since May 20. Yields indicate that the increase in bank-borrowing costs due to the European debt crisis is beginning to ease. The London interbank offered rate, which banks pay for three-month loans in dollars, was unchanged at 0.536 percentage point today, according to the British Bankers’ Association. It climbed for 13 straight days to May 27. ‘Bed of Nitroglycerine’ U.K. government debt investors are gaining confidence in Prime Minister David Cameron’s plan to tame a budget deficit that the world’s biggest bond-fund manager described as a “bed of nitroglycerine.” Ten-year gilt yields fell to the lowest in more than seven months on May 25, a day after the government announced 6.25 billion pounds ($9.1 billion) of spending cuts for 2010. Fidelity International, Loomis Sayles & Co. and investors overseeing more than $1 trillion say Cameron, 43, will reduce the biggest deficit among the Group of Seven nations and avoid a downgrade of the U.K’s AAA credit rating. The coalition said it designed the cuts to send a “shockwave” through state departments and promised a “comprehensive and credible” plan to tackle the 156 billion-pound shortfall. “The market is inclined to give the new coalition government the benefit of the doubt and see what the spending cuts look like,” said David Rolley, who helps oversee $106 billion as co-head of global fixed-income in Boston at Loomis Sayles. To contact the reporter on this story: Matthew Brown in London at mbrown42@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net.

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