* Prices slip in the face of government debt supply
* Good demand in sale of $35 billion of 2-year notes
* TIPS sale was sign some think Fed can reflate economy (Adds 2-year note auction results, updates prices)
NEW YORK, Oct 26 (Reuters) - U.S. Treasuries fell on Tuesday as traders cut prices in the face of new debt supply, with a two-year note auction drawing solid demand despite a yield less than half a percentage point above zero.
However, traders said a massive price 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 sold $35 billion in two-year notes at a record-low yield of 0.4 percent.
“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.
The two-year auction follows Monday’s sale of five-year inflation-protected Treasury bonds, which sold with a negative yield for the first time ever, showing some investors believe the Fed’s second phase of quantitative easing will succeed in spurring some inflation.
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.
The Treasury will sell $35 billion of five-year Treasury notes on Wednesday and $29 billion of seven-year notes on Thursday.
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 also been buying Treasury debt with proceeds from sales of their own currency.
In addition, the deflationary forces 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 1-9/32 in price with their yields rising to 3.99 percent from 3.91 percent late on Monday.
Benchmark 10-year Treasury notes US10YT=RR fell 15/32, their yield rising to 2.63 percent from 2.56 percent.
Traders cited technical resistance between 2.555 percent and 2.53 percent on the 10-year yield and support at 2.645 percent.
Readings on August home prices and October consumer confidence had little discernible impact on the market. For details see [ID:nN26144414]. (Reporting by Chris Reese and Ellen Freilich; Editing by Andrew Hay)