* Prices slip before Treasury auctions
* Good demand expected for 2-year notes at 1 p.m. sale
* TIPS sale was sign some think Fed can reflate economy (Updates comment, prices before 2-year auction)
By Ellen Freilich
NEW YORK, Oct 26 (Reuters) - U.S. Treasuries prices fell on Tuesday as traders cut prices before a two-year Treasury note auction expected to draw demand from risk-averse investors despite a yield less than half a percentage point above zero.
Traders said a big retreat was unlikely because the Federal Reserve meeting - at which the U.S. central bank is expected to say it will buy sizable amounts of assets to try to revive economic growth and avert deflation - is only one week away.
The Treasury will sell $35 billion in two-year notes at 1 p.m. (1700 GMT). At midday, the two-year notes to be auctioned yielded 0.413 percent in when-issued trade, slightly more than what they yielded in when-issued trade on Monday, but less than consumer price inflation for the last year.
“Investors are very risk averse and willing to accept a low yield rather than take a lot of risk in longer maturity issues or in riskier assets,” said Gary Thayer, chief macrostrategist at Wells Fargo Advisors in St. Louis, Missouri, with more than a trillion dollars in assets under management. “We expect that even though the yield is low, there will be good demand.”
Traders said in the last six two-year note auctions, the high yields have come in lower than the yield at which two-year notes traded at the same time in the open market.
Monday’s sale of five-year inflation-protected Treasury bonds with a negative yield showed some investors believe the Fed’s second phase of quantitative easing will succeed in spurring some inflation. Demand for coupon auctions this week will come from investors who are risk-averse and from people who think deflation might still take hold.
If policymakers cannot avert deflation, then a yield that looks low in absolute terms, will not be low when measured in terms of purchasing power.
Mohamed El-Erian, chief executive officer and co-chief investment officer at PIMCO, on Monday said if an investor believes in deflation or a double-dip recession, fixed-income instruments made sense.
El-Erian said the Fed’s policy statement next week would contain some “constructive ambiguity” but offer some specifics on asset purchases because the market has already “priced in quite a lot.” It will be an open-ended commitment, he told a meeting of the Financial Women’s Association in New York.
But El-Erian said what was also likely to happen is that quantitative easing will not be that effective. A lot of the liquidity will leave the United States, raising commodity prices and weakening other currencies, he said.
Quantitative easing is designed to push the return on safe assets so low that investors or companies feel they must do something more productive with their money, either invest it in other riskier assets with higher returns or, in the case of a company, spend some of their cash to expand or hire people.
Bonds have been trading near record low yields because the market expects the Fed to enter the market as a major, if not overwhelming buyer of Treasury debt, traders said.
The Fed is expected to announce a second round of quantitative easing — known as QE2 — consisting of accelerated purchases of government securities after its policy meeting on Nov. 2-3. Foreign central banks have been buying Treasury debt with proceeds from sales of their own currency.
In addition, the deflationary forces that the Fed is attempting to thwart favor fixed-income securities because deflation enhances the purchasing power of those investments.
Thirty-year bonds US30YT=RR on Tuesday fell a point, their yields rising to 3.97 percent from 3.91 on Monday.
Benchmark 10-year Treasury notes US10YT=RR fell 13/32, its yield rising to 2.62 percent from 2.56 percent on Monday.
Traders cited technical resistance between 2.555 percent and 2.53 percent on the 10-year yield and support between 2.61 percent and 2.645 percent.
Readings on August home prices and October consumer confidence had little discernible impact on the market. (Editing by Andrew Hay)