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Reserve might raise interest rates next quarter

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NEW YORK — U.S. Treasuries fell after the economy unexpectedly grew last quarter, fueling speculation the Federal Reserve will begin raising interest rates as soon as the second quarter.

"The recession will be much more shallow than expected, and the recovery much quicker than expected," said Tony Crescenzi, chief bond strategist at Miller Tabak & Co.

Gross domestic product grew 0.2 percent in the final quarter of 2001, the Commerce Department said. Economists polled by Bloomberg News had expected the economy to shrink 1.1 percent, after a 1.3 percent contraction in the third quarter.

The benchmark 10-year note fell more than 1/8 point, or $1.88 per $1,000 face amount, to 100 1/4. Its yield rose 2 basis points to 4.96 percent. Yields on two-year notes—among the securities most-sensitive to changes in Fed rates—jumped 7 basis points to 3.05 percent.

A majority of economists surveyed by Bloomberg expect Fed policy makers to leave the target rate unchanged today for the first time at a policy meeting since December 2000. The Fed lowered the rate 11 times last year to a 40-year low of 1.75 percent. Central bankers are slated to release a statement on rates at about 2:15 p.m.

Implied yields on Eurodollar futures—a gauge of three-month interest rates—rose as traders increased bets on Fed rate increases. The implied yield on June Eurodollar futures contracts climbed 4.5 basis points to 2.32 percent. The yields are typically 18 to 25 basis points above the Fed target.

Bush Speech

"With the economy showing some positive signs of strength, traders are trying to position themselves for the next Fed move," said Bryan White, who helps manage about $50 billion in money market assets at First Union in Charlotte.

Bond prices also slumped after President George W. Bush last night called for more spending on the military, homeland security and education, and tax cuts to help the economy emerge from recession. That may lead to larger debt sales and increase the amount of tradable U.S. securities above forecasts.

"Politically, it will be almost impossible for Democrats to resist the president's request for increased security and military spending," said Ward McCarthy, an economist with Stone & McCarthy Research Associates in Princeton, New Jersey.

The Treasury said it will sell $29 billion in five- and 10-year notes at its quarterly auction next week, more than the $27 billion to $28 billion expected by economists.

The increases in note sales—the two-year note auction this month was a record $25 billion—may help shrink the yield gap between two- and 10-year U.S. debt, analysts said. The resumption of the Treasury's program to repurchase bonds may help keep yields low on debt maturing in 10 years or more, said Mario DeRose, a fixed-income strategist at Edward Jones & Co. in St. Louis.

While the Treasury sales are larger-than-expected, the GDP report was "the final nail in the coffin" for two-year notes, Derose said. He said the yield on the two-year note may rise "quickly" to 3.25 percent.

The yield spread between the two securities narrowed 3 basis points to 1.92 percentage points, down from 2.14 points on Jan. 11. That creates what traders call a flatter yield curve, or the graphic depiction of Treasury rates from three-months to 30-years.