By Susanne Walker and Daniel Kruger

June 11 (Bloomberg) -- Treasury 10-year note yields reached 4 percent for the first time since October on concern surging budget deficits and a falling dollar will prompt investors to reduce holdings of U.S. debt as issuance climbs to a record.

Treasuries tumbled 6.5 percent so far this year, the worst performance since Merrill Lynch & Co. began tracking returns in 1978, as so-called bond vigilantes drove up yields to punish President Barack Obama for quadrupling the budget shortfall to $1.85 trillion and raising the risk of inflation. Ten-year notes rose as the highest yields in seven months lured investors.

"Clearly the supply issue is having a far-reaching impact on yields," said Jeffrey Caughron, an associate partner in Oklahoma City at The Baker Group Ltd., which advises community banks investing $20 billion of assets. "Virtually all can be attributed to the supply issue. The economic data has not been that bond bearish."

The yield on the 10-year note fell three basis points, or 0.03 percentage point, to 3.93 percent, after climbing as high as 4.0038 percent, at 12:28 p.m. in New York, according to BGCantor Market Data. The yield last touched 4 percent on Oct. 16. The 3.125 percent security maturing in May 2019 rose 6/32, or $1.88 per $1,000 face amount, to 93 15/32.

"Four percent's going to be seen as a very good entry point," said George Goncalves, chief fixed-income rates strategist at Cantor Fitzgerald LP, one of 16 primary dealers that trade with the Federal Reserve. "It's proving to be a good spot to draw out value players."

Borrowing Costs

The rise in yields is undermining Federal Reserve Chairman Ben S. Bernanke's efforts to cap consumer borrowing costs and pull the economy out of the worst recession in five decades.

Ten-year yields have risen over 140 basis points since the Fed announced its $300 billion, six-month Treasury purchase program on March 18. The average 30-year mortgage rate jumped to 5.59 percent from 5.29 percent a week earlier, Freddie Mac, the McLean, Virginia-based mortgage buyer, said today in a statement. The 15-year rate averaged 5.06 percent.

Yields on Washington-based Fannie Mae's current-coupon 30- year fixed-rate mortgage bonds were at 5.07 percent, according to data compiled by Bloomberg. That's the highest since Nov. 24, the day before the U.S. central bank announced its plans to buy home-loan bonds, and up from 3.94 percent on May 20.

Policy makers "now need to accept that they can't control the back end and need to focus on the front end," said Dominic Konstam, head of interest-rate strategy in New York at Credit Suisse Group AG, another primary dealer.

Thirty-Year Auction

The 30-year bond yield touched 4.8391 percent, the highest since October 2007. The government is scheduled to sell $11 billion of the securities today.

Thirty-year bonds drew a yield of 4.288 percent at the previous auction of the securities on May 7. Investors bid for 2.14 times the amount of debt for sale last month, versus an average of 2.21 times for the past 10 auctions. The sale is the third auction this week as the Treasury raises $65 billion.

The Treasury's auction of $19 billion in 10-year notes yesterday drew a yield of 3.99 percent, the highest since August 2008. The sale was the second of three sales this week that will raise $65 billion.

Indirect bidders, the class of investors that includes foreign central banks, bought 34.2 percent of the notes, up from 31.9 percent in May. The average at the past 10 scheduled auctions is 25.8 percent.

Big Leagues

Russia and Brazil announced plans yesterday to buy $20 billion of bonds from the IMF and diversify foreign-currency reserves. China will purchase $50 billion and India may announce similar funding, Brazil's Finance Minister Guido Mantega said.

"They're saying they are part of the big leagues," Alberto Ramos, an economist in New York at primary Goldman Sachs Group Inc.. "They're not buying IMF bonds to diversify reserves. They want to be seen as having a large voice" in global markets, he said.

Russia holds $138.4 billion of U.S. debt. China is the largest U.S. creditor, with $767.9 billion. The U.S. government must rely on foreign investors to sustain record borrowing.

While leaders of the nations of Brazil, Russia, India and China talk about substituting the dollar, the so-called BRIC countries have increased foreign reserves at the fastest pace since September. The nations added more than $60 billion in foreign reserves in May to limit currency gains, data compiled by central banks and strategists show.

Foreign Reserves

The Dollar Index, used by the ICE to track the greenback against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, fell 0.34 percent to 80.04.

Many of those reserves are still being plowed into U.S. debt securities, according to data from the Fed. Its holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $68.8 billion, or 3.7 percent, in May, the third most on record, data compiled by Bloomberg show.

Former Federal Reserve Chairman Paul Volcker said there are "no practical alternatives" to the dollar as an international currency.

"The ultimate logic of a globalized financial system is a world currency," Volcker, head of Obama's Economic Recovery Advisory Board, said today in the text of a speech delivered in Beijing. "There are no practical alternatives today or for many tomorrows of the United States dollar as an international currency."

Budget Deficit

Yields are also rising as the economy shows signs of recovering. A report today showed sales at U.S. retailers rose in May for the first time in three months. Purchases climbed 0.5 percent, as forecast, after a revised 0.2 percent drop in April that was smaller than first reported, the Commerce Department said in Washington.

The U.S. may borrow $3.25 trillion in the fiscal year ending Sept. 30, almost four times the $892 billion in 2008, according to Goldman Sachs. The budget deficit is projected to increase to $1.85 trillion in the year ending Sept. 30, equivalent to 13 percent of the nation's economy, according to the nonpartisan Congressional Budget Office.

All told, the government and the central bank have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s.

For the moment, at least, inflation isn't a cause for concern. During the past 12 months, consumer prices fell 0.7 percent, the biggest decline since 1955. Excluding food and energy, prices climbed 1.9 percent from April 2008, according to the Labor Department.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, reached 2.13 percentage points yesterday, a 10-month high.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net