Oct. 11 (Bloomberg) -- Treasury 10-year notes posted the biggest weekly drop in four months as traders anticipated the U.S. government will sell more debt to fund a rescue of the financial system.

The decline yesterday pushed yields on 10-year securities to the highest since mid-August. The government sold $40 billion in debt in special auctions this week to relieve shortages in lending markets. It also said it would continue increasing sizes of regular debt sales and consider selling new maturities.

``It's largely a supply story -- you have to look at the amount of Treasury-funded packages that have been approved,'' said Jamie Jackson, who oversees government debt trading at Minneapolis-based RiverSource Investments. Jackson said his fund owns fewer Treasuries than contained in the benchmark he uses to measure performance.

The 10-year note's yield rose this week by 27 basis points, or 0.27 percentage point, to 3.87 percent, according to BGCantor Market Data. It was the biggest five-day increase since the period ended June 13, after the Federal Reserve intensified indications it would fight inflation by raising interest rates. Policy makers instead held the rate steady, before cutting it this week. The yield yesterday touched 3.90 percent, the highest since Aug. 15.

The 4 percent security due in August 2018 dropped this week 2 1/4, or $22.50 per $1,000 face amount, to 101.

Two-year notes had the first five-day drop in almost two months, pushing up yields 5 basis points to 1.63 percent.

`Not a Bond Bull'

``The U.S. Treasury will need to sell a lot of bonds over the coming months to finance the burgeoning federal budget deficit,'' said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG's Private Wealth Management unit in New York. ``And why should you buy today when probably you can buy at higher yields tomorrow? I'm not a bond bull anymore.''

Investors are demanding higher yields on U.S. debt as the biggest government intervention in financial markets since the 1930s spurs speculation U.S. funding needs will surge. In the past five weeks, the government has taken over mortgage-finance firms Fannie Mae and Freddie Mac, rescued insurer American International Group Inc., backed the deposits of money-market funds and authorized a $700 billion bank rescue program.

The Treasury also plans to buy stakes in banks within weeks, two officials informed of the matter said Oct. 9.

The 2009 budget deficit could be close to $2 trillion, or 12.5 percent of gross domestic product, more than twice the record of 6 percent set in 1983, David Greenlaw, Morgan Stanley's chief economist, told Bloomberg this week. The deficit accounted for 2.2 percent at the end of the second quarter.

Margin Calls

Some traders sold government securities this week to raise cash for margin calls, or payment demands on assets purchased with borrowed money, as U.S. stocks sank. The Standard & Poor's 500 Index tumbled 18.2 percent, its worst week since 1933.

``We went through a margin call like no other at a time when people were scrambling for cash,'' said George Goncalves, chief Treasury and agency strategist with Morgan Stanley in New York, one of the 17 primary dealers that trade bonds with the Fed. ``You sell the assets that you can actually raise money in,'' he added, referring to Treasuries.

The U.S. this week sold $40 billion in notes due in February 2015 and 2018, May 2015 and August 2015 in four auctions to relieve ``protracted shortages.'' As deteriorating capital markets boost demand for the relative safety of government debt, failures to deliver Treasuries in the $7 trillion-a-day market for borrowing and lending the securities have set a record.

Supply `to Dominate'

The government will likely increase its scheduled sale of two-year notes at month-end by $2 billion to a record $36 billion, according to Wrightson ICAP, a Jersey City, New Jersey- based research firm. The five-year note sale will also grow by $2 billion, to $26 billion, Wrightson forecast.

The Treasury said Oct. 6 it ``will continue to increase auction sizes'' and will announce any changes to its auction calendar, including a possible reintroduction of the three-year note, in its Nov. 5 quarterly refunding announcement.

``Supply is going to dominate the Treasury price action,'' said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world's largest inter-dealer broker. ``Rates are going to go higher. They have to.''

Yield Gap

As 10-year notes fell more than two-year notes this week, the gap between the securities' yields widened to 2.23 percentage points, the most since 2004. Traders may bet on a widening yield gap by selling longer-term debt and buying shorter-term securities.

Ten-year notes lost investors 1.5 percent in the week ended Oct. 9, while two-year notes slumped 0.13 percent, according to Merrill Lynch & Co.'s Treasury Master Index. The S&P 500 lost 18 percent in the same period.

Yields on short-term securities indicate investors are still seeking the relative safety of government debt. Rates on three-month Treasury bills, viewed as a haven in times of turmoil, fell 28 basis points to 0.18 percent, the lowest since Sept. 18. A year ago, the yield was 4.11 percent.

Government and central bank actions have yet to thaw the year-long freeze in money markets as banks hoard cash. The difference between what banks and the Treasury pay to borrow for three months, the so-called TED spread, widened this week to 4.64 percentage points, the most since Bloomberg began compiling the data in 1984. It was 1.18 percentage points a month ago.

Treasury Inflation Protected Securities, or TIPS, indicate traders' inflation expectations are the lowest in almost a decade amid concern that the credit-market seizure will tip the economy into recession. Ten-year TIPS yesterday yielded 0.93 percentage point less than conventional notes, the least since 1999. The yield gap reflects traders' forecast of the average inflation rate over the next 10 years. It was 2.56 percent as recently as March.

The Securities Industry and Financial Markets Association recommended a 2 p.m. market close yesterday and a full close on Oct. 13 for the U.S. Columbus Day holiday.

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net

Last Updated: October 11, 2008 08:00 EDT