By Deborah Finestone
Dec. 28 (Bloomberg) -- Treasuries rose the most in more than two weeks and headed for the best annual returns since 2002 after a government report showed sales of new homes in the U.S. declined to a 12-year low last month.
Ten-year note yields fell to the lowest level in a week after the Commerce Department said sales dropped 9 percent, compared with the forecast for a 1.6 percent decline. Treasuries have returned 8.1 percent this year as traders anticipate the Federal Reserve will extend interest-rate cuts next month.
``The argument for a potential recession has been fortified,'' said Andrew Harding, chief investment officer for fixed income in Cleveland at Allegiant Asset Management, which manages $18 billion. ``We'll see low rates for some period of time.''
The yield on the benchmark 10-year note decreased 12 basis points to 4.07 percent at 4:08 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 4 1/4 percent security due in November 2017 rose 31/32, or $9.69 per $1,000 face amount, to 101 13/32.
Ten-year notes gained for a second week, with yields falling 9 basis points. Yields have declined 63 basis points this year. Two-year yields dropped 9 basis points this week to 3.10 percent, down 1.71 percentage points this year.
The yield premium 10-year notes offer over two-year Treasuries reached 97 basis points, showing investors favor shorter-dated notes in expectation of lower interest rates. At the beginning of the year, two-year notes yielded 11 basis points more than 10-year securities, inverting the so-called yield curve.
About $158.7 billion in Treasuries traded through ICAP Plc. The three-month daily average for the world's biggest broker of trades between banks is about $312 billion.
Fed funds futures on the Chicago Board of Trade indicate a 90 percent chance the Fed will reduce its target rate for overnight bank loans a quarter-percentage point from 4.25 percent at its Jan. 30 meeting, up from 76 percent odds yesterday.
``The fed funds rate is in the wrong place,'' Paul McCulley, a money manager at Pacific Investment Management Co. in Newport Beach, California, said in an interview on Bloomberg Television. ``Recessions are always about tipping points. That's what I worry about.''
McCulley said in a note yesterday the Fed will cut rates at each upcoming meeting to at least 3 percent.
Sales of new homes fell to an annual pace of 647,000, and October sales were revised down to a 711,000 rate, according to the Commerce Department in Washington.
``It's clear that housing is a problem and is going to continue to be a problem,'' said John Canavan, a fixed-income analyst in Princeton, New Jersey, at Stone & McCarthy Research Associates. ``There's a good possibility for yields to head lower still.''
Market rates for inter-bank loans have declined since the Fed, European Central Bank and three other central banks announced a combined effort on Dec. 12 to revive that market. The rates remain above the levels of July, before the collapse of the U.S. subprime-mortgage market caused banks to stop lending to all but the safest borrowers.
The rate banks charge to lend each other dollars fell, indicating they are less concerned about having funding at year- end. The three-month London interbank offered rate, or Libor, fell 10 basis points to a 22-month low of 4.73 percent, the British Bankers' Association said.
The gap between the Libor and overnight index swap rate, viewed as an indirect measure of the availability of funds in the money market, fell to 66 basis points today, from as much as 106 basis points on Dec. 4, which was the widest since at least December 2001, as far back as Bloomberg compiles the data.
The gap averaged 11 basis points between 2001 and when credit market concern began mounting in August.
``People are beginning to get the creeping sense that funding issues will persist well into 2008,'' said William O'Donnell, head of U.S. government bond strategy in Stamford, Connecticut, at UBS Securities LLC, one of the 20 primary securities dealers that trade with the Fed. ``We continue to see slightly better buying of Treasuries.''
The ``TED'' spread, the difference between what banks and the U.S. government pay for three-month loans, narrowed to 1.58 percentage points from 2.40 percentage points in August. The gap was 32 basis points on Jan. 2.
Riots in Pakistan after the assassination of former prime minister Benazir Bhutto added to investors' desire for the safety of government debt.
`Uncertainty and Unrest'
``Global uncertainty and unrest are usually good for Treasuries,'' said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee.
Traders may also be unwinding bets that prices will fall before the weekend amid light New Year's holiday trading, Canavan said. The Securities Industry and Financial Markets Association recommended trading of Treasuries close at 2 p.m. New York time on Dec. 31 and stay shut on Jan. 1 in Japan, the U.K. and the U.S. for New Year's Day.
The Fibonacci series of numbers, a technical indicator used by some investors to identify targets, suggested 10-year yields need to hold below 4.16 percent if they are to decline further.
A move past one level in the series indicates the rate may fall or rise to another. The next target is 3.79 percent.
Yields on 10-year Treasuries will climb to 4.48 percent by the end of 2008 as investors reduce bets the world's largest economy will slide into recession, according to the median forecast of 71 economists surveyed by Bloomberg.
Returns this year were the best since gaining 11.6 percent in 2002, according to indexes complied by Merrill Lynch & Co.