Treasury two-year notes are the cheapest relative to 30-yearbonds since the end of 2007, as hawkish comments from FederalReserve officials spur speculation the central bank will increaseinterest rates this year. [See Figure 1, below.]

The yield on the shorter-maturity debt, which is more sensitiveto the outlook for monetary policy, rose for a third day after FedBank of Kansas City President Esther George said labor-market gainsand rising inflation should prompt higher interestrates. ChairJanet Yellen speaks Friday at an annual symposium in JacksonHole, Wyoming.

Fed officials “are trying to jawbone up rates, especiallyinflation expectations,” said George Goncalves, head of U.S.interest-rates research at Nomura Securities, one of 23 primarydealers that trade with the central bank. “Rates could move alittle higher tomorrow. Not because of expectations of hikes, butmore about 'Hey, the Fed means business.'”

History suggests that a Fed rate increase benefitslonger-maturity bonds more than their short-dated counterparts.Every time the Fed has raised rates over the past fourdecades, betting that longer-term Treasuries would outperformshort-term notes has proved to be a winner, according to datacompiled by Bloomberg. Higher rates helped stem inflation and keepeconomic growth from overheating.

The Treasury two-year note yield rose three basis points, or0.03 percentage point, to 0.79 percent as of 5 p.m. in New York,according to Bloomberg Bond Trader data. That's the highestclosing level since June 6. The price of the 0.75 percent securitydue in August 2018 was 99 29/32.

The extra yield investors demand to hold 30-year bonds insteadof two-year notes contracted to about 147 basis points, making thatmeasure of the yield curve the flattest on a closing-price basissince December 2007. Bob Michele, New York-based chief investmentofficer at JPMorgan Chase & Co.'s asset-management unit, whichhas $1.7 trillion under management, sees it flattening further.

“Every steepening of the curve will be met bybuying,” Michele said on Bloomberg Television. “We're going awhole lot flatter. I think we're going through 100.”

The probability of a rate increase by September was 32 percent,compared with an 18 percent chance seen at the start of the month,according to data compiled by Bloomberg from fed fund futures.Traders see about a 57 percent chance of a move this year. The oddshave risen after Vice Chairman Stanley Fischer joined thepresidents of the New York and San Francisco branches in signalinga move in 2016 was still under consideration.

Treasury Auctions

Economic data on Thursday showed orders for U.S. businessequipment climbed for a second month in July, the firstback-to-back advance since early 2015. Steadier orders would markan improvement in demand for capital spending that Fed policymakers have described as “soft.”

A gauge of demand fell to the lowest since February at a $28billion auction of seven-year notes Thursday. The decline in buyerinterest comes after a $34 billion five-year debt sale Wednesdaysaw the greatest demand on record from indirect bidders, a class ofinvestors that includes foreign central banks and mutual funds.Demand at a $26 billion two-year note auction on Aug. 23 was thehighest since May.

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