By Cordell Eddings Aug. 5 (Bloomberg) -- Treasury 10-year notes advanced after a government report showed U.S. initial jobless claims unexpectedly increased last week, adding to evidence that the U.S. economic recovery is stalling. The added yield investors demand to hold 10-year notes instead of 2-year debt narrowed as investors reduced inflation expectations before the Labor Department’s non-farm payrolls report tomorrow. The possibility of deflation and another recession is 25 percent, according to Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co. “Labor markets are recovering slowly, which is keeping consumer confidence down, spending down and rates down,” said Guy Lebas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia. “The higher-than-expected number cast a bit of a negative shadow on Friday’s data, which is adding a bit of buying pressure to the markets.” The 10-year note yield dropped three basis points, or 0.03 percentage point, to 2.92 percent at 10:47 a.m. in New York, according to BGCantor Market Data. The price of the 3.5 percent security maturing in May 2020 increased 9/32, or $2.81 per $1,000 face amount, to 104 7/8. The yield on the two-year note slid two basis points to 0.55 percent after falling on Aug. 3 to a record low 0.5143 percent. The 10-year yield dropped on Aug. 4 to 2.88 percent, the lowest level since July 22. Pimco’s Holdings Bill Gross, who runs the $239 billion Pimco Total Return Fund, increased holdings of government-related debt in June to the highest level in eight months, according to the Newport Beach, California-based company’s website. Unemployment will stay unusually high, said Pimco’s El- Erian in a briefing for reporters today in Tokyo. Companies are accumulating cash and individuals are saving, making it tougher to counter deflation, he said. That reduction in private-sector spending makes government policies to stimulate the economy less effective, according to El-Erian. The number of Americans filing first-time claims for unemployment insurance rose to 479,000 in the week ended July 31 from a revised 460,000 in the previous week, the Labor Department reported today. The median forecast of 43 economists in a Bloomberg News survey was for a decrease to 455,000 from the previously reported 457,000. The U.S. lost 65,000 jobs last month, according to the median forecast of 81 economists in a Bloomberg News survey before the Labor Department’s payrolls report tomorrow. The unemployment rate probably climbed to 9.6 percent from 9.5 percent, the survey showed. Job Market Concern “Treasuries are certainly benefiting from fears that the jobs figure will be another nail in the coffin for the economy,” wrote Thomas L. di Galoma, head of U.S. rates trading in New York at Guggenheim Partners LLC, a brokerage for institutional investors, in a research note. “The jobless claims number now implies downward risk to non-farms payrolls.” The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices, has narrowed to 1.82 percentage points from this year’s high of 2.49 percentage points in January. Futures contracts on the CME Group Inc. exchange show a reduced 40 percent chance that policy makers will increase the target rate for overnight lending between banks by at least a quarter-percentage point by August 2011, down from 55 percent odds a week ago. Fed’s Target Range The Fed has maintained a range of zero to 0.25 percent since December 2008 to encourage the economic recovery. Policy makers are scheduled to meet Aug. 10. U.S. economic growth slowed to a 2.4 percent annual rate in the second quarter from a 3.7 percent pace in the first three months of the year. Consumer spending, pending home sales and factory orders were all weaker than projected in June. The yield curve may steepen as demand from investors taking refuge from economic uncertainty push the 2-year yield down while the 10-year yield rises because of next week’s auction of the longer maturity, according to CRT Capital Group. “Twos continue to set record low yields on flight-to- quality demand,” said Ian Lyngen, an analyst at CRT in Stamford, Connecticut, in an interview yesterday. The difference in yield between the two maturities fell today to 2.37 percentage points, from 2.39 percentage points. The spread was 2.28 percentage points on July 1, the narrowest since October. The government will auction $34 billion in three-year notes on Aug. 10, $24 billion in 10-year debt the following day and $16 billion in 30-year bonds on Aug. 12. To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

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