Ten-year yields hit 16-month low as global growth ebbs

Treasuries extended their sharp rally, boosted in part by gains in Japanese government bonds after data showed second quarter growth slowed to just 0.1 percent, while previous quarters saw sharp downward revisions.

Treasuries pared gains as Asian shares trimmed losses after an early slide, led by gains in Shanghai <.SSEC>. The bounce in equities helped pull S&P futures into positive territory from an initial drop of about 0.5 percent.

Ten-year JGB yields hit a seven-year low of 0.950 percent as the Japanese GDP report highlighted the struggles of the economy to escape deflation, with nominal GDP plunging at a 3.7 percent annual rate.

Faltering growth, weak bank lending and expectations for the Federal Reserve to expand its quantitative easing policy by buying Treasuries have pushed yields sharply lower.

The Fed spooked investors last week by downgrading its expectations for the U.S. economy and taking a first step toward more quantitative easing by shifting maturing mortgage bonds into Treasuries.

Although the amount of Treasuries that will be purchased is small relative to the total supply, it does open up the possibility of large scale quantitative easing if the economy declines further, said fixed-income strategists at Deutsche Bank in a weekly note to clients.

The chance of significant weakness is fairly high, with the primary cause the shrinking of credit on a global scale, given the instability of interbank funding, the continued workout of impaired assets and the uncertainties of financial regulation, the Deutsche strategists said.

Thirty-year Treasuries outperformed and the 10-year/30-year curve flattened, reversing some of the steepening that had driven that spread to a record peak last week.

Ten-year yields were down a basis point at 2.669 percent and touched a 16-month low of 2.651 percent, falling as much as 24 basis points this month.

Thirty-year yields dipped 1.3 basis points to 3.849 percent, causing the 10-year/30-year spread to shrink slightly.

September T-note futures were up 2.5/32 at 125-21/32 after touching a 17-month peak of 125-26/32 on fairly active trade of nearly 31,000 lots in Asia.

Part of the drop in Treasury yields over the past week has been due to investors cutting inflation expectations over the medium term, as reflected in inflation-protected bonds.

The 10-year breakeven inflation rate -- the difference between yields on regular Treasuries and TIPS, showing expected average inflation over that time horizon -- has fallen to 1.68 percent, back near its lowest levels in a year and down 17 basis points in the past two weeks.

(Reporting by Eric Burroughs; Editing by Kim Coghill)