* Benchmark 10-year note yields lowest in two weeks
* Fiscal, economic fears seen boosting Treasuries
* Fed purchases $4.99 bln in last Twist buyback
By Karen Brettell
NEW YORK, Dec 28 U.S. benchmark Treasuries
yields fell to their lowest levels in two weeks on Friday as
hopes faded for a deal to avoid tax hikes and spending cuts that
could throw the U.S. economy into recession.
Investors are focused on Washington as President Barack
Obama and lawmakers launch a last-chance round of budget
negotiations days before a New Year's deadline to reach a deal
or watch the economy go off a "fiscal cliff."
Window-dressing for year-end and month-end extension buying
also boosted demand for Treasuries on the second last trading
day of 2012.
"The market has lost the optimism it had over a deal getting
done, it was much more optimistic a week ago," said Jason Rogan,
managing director in Treasuries trading at Guggenheim Partners
in New York.
Treasuries temporarily pared prices gains on Friday after
President Obama was reported by news outlets including Bloomberg
as saying he would offer a scaled back budget package today.
"I still think it's unlikely that a deal will go through,
but it seems like a step in the right direction so the market
came off," said Sean Murphy, a Treasuries trader at Societe
Generale in New York.
Bonds then recaptured their price gains as the Federal
Reserve bought $4.99 billion in notes due 2021 and 2022 in its
final Operation Twist program, in which it buys long-term notes
and funds the purchases with sales of short-term notes.
The central bank will replace that operation next year with
outright purchases of Treasuries from 5-years to 30-years as it
seeks to boost spending and economic growth.
Concerns that lawmakers will fail to reach a deal to resolve
the fiscal crunch by year-end is expected to keep a bid for safe
haven Treasuries in the coming days, or weeks.
"I think the most likely scenario is that we will probably
go over the cliff, there is a lot of posturing on both sides,"
said John Fath, managing partner at BTG Pactual in New York.
Many investors expect that negotiations will extend beyond
Monday's deadline, but that some kind of agreement is likely in
the first few weeks of January.
"There is the assumption that something will get done. As
time continues to go on with no deal taking place I think you
will start to see the market really start to get a
flight-to-quality bid," said Guggenheim's Rogan.
Some also fear that lawmakers are unlikely to reach a
substantive consensus on how to reduce the U.S. deficit, with
the most likely outcome that they will agree on smaller issues
in early January and then push back negotiations on larger
issues to later in 2013.
This may also increase the risk of further negative actions
on the U.S. credit rating.
Treasuries rallied when Standard & Poor's cut the U.S.
credit rating to the second highest investment grade in August
2011, though investors have said there's no certainty the market
will react the same way a second time.
"The kneejerk reaction is that there could be a move to
flight-to-quality," said BTG's Fath. Longer term, "there might
be a bit of an illusion in the marketplace, particularly with
lawmakers, that it will have no effect or bearing on rates, but
at some point it will."
Fitch Ratings and Moody's Investors Service both rate the
U.S. the top triple-A and all three major rating agencies have a
negative outlook on the country.
Benchmark 10-year notes were last up 7/32 in
price, with yields falling to 1.71 percent, down from 1.73
percent on Thursday and from a two-month high of 1.85 percent a
week and a half ago.
Thirty-year bonds rose 12/32 in price to yield 2.89 percent,
down from 2.90 percent on Thursday and the lowest since Dec. 17.