February 13, 2011, 11:40 PM EST By Wes Goodman

Feb. 14 (Bloomberg) — Treasury two-year yields were near the highest level in eight months before reports this week forecast to show gains in retail sales and industrial production.

The difference between two-year rates and the Federal Reserve’s target for overnight bank lending was 58 basis points, after widening to 60 basis points on Feb. 8, which was the most since May. The increase in Treasury rates is poised to accelerate, Morgan Stanley, one of the 20 primary dealers that are authorized to trade with the central bank, said in a report.

“Retail sales and medium and small companies are performing quite well,” said Hideo Shimomura, who helps oversee the equivalent of $72 billion in Tokyo as chief fund investor at Mitsubishi UFJ Asset Management Co., a unit of Japan’s biggest bank. “It’s good news for equities and bad for Treasuries.

Two-year notes yielded 0.83 percent at 1:20 p.m. in Tokyo, according to BGCantor Market Data. The 0.625 percent security maturing in January 2013 traded at a price of 99 19/32. The rate climbed to 0.86 percent on Feb. 9, which was the most since May 28. Ten-year yields were little changed at 3.63 percent.

An index of U.S. government securities maturing in more than a year has handed investors a 1.3 percent loss this month, the worst performance of 26 sovereign bond markets tracked by the European Federation of Financial Analysts Societies and Bloomberg. The MSCI All Country World Index of stocks returned 2.3 percent in the period.

The MSCI Asia Pacific Index of shares rose 1.4 percent today, the most in two months, eroding demand for the relative safety of government debt.

Retail Sales, Production

Mitsubishi UFJ trimmed its Treasury holdings this year, Shimomura said. He pointed to the National Federation of Independent Business’ optimism index, which rose to a three-year high in January, as evidence that small companies are improving.

Retail sales climbed 0.5 percent in January, extending a 0.6 percent increase in December, based on the median forecast of economists surveyed by Bloomberg News before the Commerce Department reports the figure tomorrow. Federal Reserve figures on Feb. 16 may show industrial production rose 0.5 percent in January from the month before, the surveys show.

“The bloom is off the bond rose,” Morgan Stanley analysts led by Jim Caron, the head of U.S. interest-rate strategy in New York, wrote in their report Feb. 11.

Treasury rates have risen enough that some investors said they are becoming attractive.

‘Cheap’ Yields

“Yields are relatively cheap,” said Hiromasa Nakamura, a senior investor at Mizuho Asset Management Co. in Tokyo, which oversees the equivalent of $42.1 billion and is a unit of Japan’s second-largest bank. “Consumer spending is recovering, but I don’t think it is sustainable due to the fragile employment situation.”

The U.S. unemployment rate fell to 9 percent in January from 9.4 percent in December. It hasn’t been less than 9 percent since April 2009.

Fund managers became less bearish on the outlook for Treasuries through March, according to a weekly survey by Ried Thunberg ICAP Inc. Ried’s sentiment index rose to 49 for the seven days ended Feb. 11 from 45 the week before. A figure less than 50 indicates investors expect prices to decline.

The fund managers surveyed turned more pessimistic when asked about the outlook for Treasuries through June 30.

Mizuho Asset’s Nakamura said he’s favoring 10-year notes in a bet inflation will stay low.

The consumer price index advanced 0.3 percent in January, slowing from the 0.5 percent gain in December, according to the median forecast in a Bloomberg News survey of economists before the Labor Department figure Feb. 17.

Consumer Price Report

The consumer-price report will also show costs excluding food and energy increased 0.9 percent in January from a year earlier, the Bloomberg surveys show. The average for the past decade is 2 percent.

Inflation may “persist below the levels that Fed policy makers have judged to be consistent” with their long term goal, Federal Reserve Chairman Ben S. Bernanke told legislators last week.

The difference between yields on 10-year notes and Treasury Inflation Protected Securities a gauge of trader expectations for consumer prices over the life of the securities, widened to 2.30 percentage points from 1.65 percentage points six months ago.

‘Train Wreck’

While some of the lowest borrowing costs on record have helped the U.S. economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expenses will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the government’s adjusted 2011 budget.

“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”

The amount of marketable U.S. government debt outstanding has risen to $8.96 trillion from $5.8 trillion at the end of 2008, according to the Treasury Department.

–With assistance from Daniel Kruger and Liz Capo McCormick in New York. Editors: Nate Hosoda, Nicholas Reynolds

To contact the reporter on this story: Wes Goodman in Singapore at wgoodman@bloomberg.net.

To contact the editor responsible for this story: Nicholas Reynolds at nreynolds2@bloomberg.net

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