The Treasury Department successfully auctioned $16 billion of two-year notes on Tuesday, sparking a rally in the government securities market.

The average yield on the notes was 3.94%, versus 4.26% at the previous auction, on July 27.

"The yield was at the low end of expectations," said Astrid Adolfson, economist at MCM MoneyWatch.

Prior to the start of bidding, the notes were yielding 3.96% in when-issued trading.

Indicating the strong demand, bids exceeded accepted offers by a ratio of 3.49 to 1.

In the last year, the average "bid-cover ratio" for two-year notes is 2.4 to 1, said William Sullivan, money market economist at Dean Witter, Discover & Co.

Market analysts said the strong auction reflected big demand from municipalities, which use the notes to back municipal bond defeasance programs.

Short-Term Rates Seen Low

In addition, recent signs of weakness in the economy have convinced investors that the Federal Reserve will not raise short-term interest rates now.

Thus, investors can buy shorter-term securities without fear of a Fed-induced price drop.

"The data have been so weak that people are no longer afraid of a tightening," Ms. Adolfson said.

Mr. Sullivan said strong demand from banks also supporteed the auction.

Bond Prices Buoyed

The rally in bond prices, which stumbled in the last two trading sessions, got new life from the auction.

At 4 p.m., the price of the 30-year bond was up 3/8, lowering the yield to 6.19% from 6.22% on Monday. Most of the gains occurred after the auction, when Treasury bond futures prices hit contract highs.

Prices of current-coupon intermediate Treasuries also moved up.

10-Year Note Gains

The price of the 10-year note rose 1/2, lowering the yield to 5.55% from 5.60%. Five-year notes - of which a new issue will be launched today - rose by about 3/8 in price. Their yield fell to 4.87% from 4.96%.

The bond-equivalent yield of the one-year Treasury bill fell to 3.36% from 3.40%.

Mr. Suilivan thinks that market participants may be returning to yield-curve-steepening trades.

For months, traders have been buying longer-term securities in anticipation of a flattening of the yield curve.

Low Yields Lift Stocks

Low yields in the bond market pushed up stocks prices. The Dow Jones industrial average climbed 32.98 points to a record 3,638.96. At the same time, the Standard & Poor's 500 index rose 4.54 to 459.77, and the Nasdaq composite index advanced 4.25 to 735.11.

The dollar was mixed as the foreign exchange market awaited Thursday's Bundesbank meeting. Some traders and economists think the German central bank

will lower interest rates at that meeting.

The currency finished at 103.63 Japanese yen, up from 103.05, and at 1.6775 German marks, down from 1.6835.

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