Nov. 6 (Bloomberg) -- Treasury two-year note yields touched the lowest levels since May after the U.S. unemployment rate rose to a 26-year high of 10.2 percent, reinforcing expectations the Federal Reserve won’t raise rates for an extended period.

Two-year notes gained for a second week after the Labor Department reported payrolls shrank by 190,000 workers last month, compared with a 175,000 drop anticipated by the median forecast of a Bloomberg News survey. The difference between 2- and 10-year Treasury note yields touched 2.70 percentage points, the most since July 27, as the U.S. prepared to sell $81 billion of notes and bonds next week.

“An unemployed consumer will be less likely to spend,” said Ian Lyngen, senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut. “It brings into question the pace of the recovery. There will be a major source of resource slack in the market for the time being.”

Two-year note yields fell three basis points, or 0.03 percentage point, to 0.85 percent at 4:24 p.m. in New York, according to BGCantor Market Data. The yield touched 0.8321 percent, the lowest since May 21. The 1 percent security maturing in October 2011 rose 2/32, or 63 cents per $1,000 face amount, to 100 9/32. The yield declined five basis points on the week. Ten-year note yields fell two basis points to 3.50 percent, rising 11 basis points for the week.

Unemployment Peak

The so-called underemployment rate -- which includes part- time workers who’d prefer a full-time position and people who want work but have given up looking -- reached a record 17.5 percent from 17 percent in September.

“We believe the unemployment rate is going to peak this quarter, because improved economic growth should bring with it higher labor input,” wrote Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc., in New York, in a note to clients. The firm is one of 18 primary dealers that trade with the Fed.

Record-low interest rates and Fed purchases of Treasuries and mortgage debt, combined with the Obama administration’s $787 billion fiscal stimulus, helped boost gross domestic product 3.5 percent from July to September. Without the auto industry, which benefited from the government’s “cash for clunkers” program, growth would have been 1.9 percent.

U.S. economic growth will slow to 2.4 percent this quarter, according to a Bloomberg survey of banks and securities companies.

‘Out of Gas’

The U.S. economic recovery will probably “run out of gas” as it heads toward a “new normal” of lower long-term growth and higher unemployment than over the previous decade, Nobel laureate Edmund Phelps said.

While the economy grew the most in two years in the third quarter and the decline in payrolls may bottom in the first quarter of 2010, that doesn’t change the fact that the economy has lost its “dynamism,” Phelps said in an interview with Bloomberg Television.

Two-year note yields declined on Nov. 4 after the Fed reiterated that its target rate will stay near zero for an “extended period.” The central bank said that its commitment to “exceptionally low” rates depends on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”

The government plans to sell $40 billion of 3-year notes, $25 billion of 10-year debt and $16 billion of 30-year bonds next week. The amounts are all records, according to data compiled by Bloomberg. It will also reintroduce 30-year Treasury Inflation Protected Securities, or TIPS, and stop issuance of the 20-year inflation-linked security.

Bets Pushed Back

“The long end of the yield curve is coming under some pressure as the curve continues to steepen going into next week’s quarterly refunding,” Kevin Giddis, head of fixed-income sales, trading and research at the brokerage Morgan Keegan Inc. in Memphis, Tennessee, wrote in a note to clients. “As long as inflation remains low, the Fed is going to want to see some real good signs of a job recovery before it removes liquidity in a big way.”

Futures traders are pushing back bets for when the Fed will begin to increase interest rates. Fed-funds futures contracts, which traded on the Chicago Board of Trade, show traders expect a 52.6 percent probability the central bank will lift its target rate for overnight bank borrowing to at least 0.5 percent by June from its current range of zero to 0.25 percent. That’s down from 57.1 percent odds yesterday.

The difference between rates on 10-year notes and TIPS touched 2.19 percentage points, the most since Aug. 28, 2008, indicating concern about rising consumer prices was the highest since before the collapse of Lehman Brothers Holdings Inc.

Gold futures jumped to a record, topping $1,100 an ounce, on mounting speculation that low U.S. borrowing costs will drive the dollar lower, boosting the appeal of the precious metal as an alternative investment.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Daniel Kruger in New York at dkkruger1@bloomberg.net.

Last Updated: November 6, 2009 16:29 EST