Two-year Treasury yields fell to an 18-month low as investors sought the safety of government debt amid signs that losses linked to American subprime mortgages are mounting.

Two-year notes, more sensitive to interest-rate expectations, gained as traders stepped up bets the Federal Reserve will cut borrowing costs. Merrill Lynch & Co. downgraded Countrywide Financial Corp., the biggest American mortgage lender, to “sell” yesterday and raised the possibility of bankruptcy. Sydney-based Basis Capital Fund Management Ltd. said losses at one of its hedge funds might exceed 80%. A report showing slowing inflation also boosted debt.

“As long as other markets remain dysfunctional the bid will remain in Treasuries no matter where inflation is,” said William O’Donnell, American government bond strategist at UBS Securities in Stamford, Conn., one of 21 firms that trade with the Fed.

The yield on the benchmark two-year note fell 3 basis points, or 0.03 percentage points, to 4.33% as of 11:46 a.m. in New York, according to bond broker Cantor Fitzgerald LP.

The price of the 4 5/8% security due July 2009 rose 1/16, or 63 cents a $1,000 face amount, to 100 17/32. Ten-year yields were little changed at 4.73%.

Consumer prices rose 0.1% in July, the least in eight months, from 0.2% in June, a government report showed. American industrial production rose 0.3% in July, after a 0.6% increase in June, the Fed said yesterday.

In a sign investors see inflation as less of a risk, regular 10-year notes yielded as little as 2.23 percentage points above 10-year inflation-linked Treasuries Tuesday, a two-year low. The difference represents investors’ expectations for inflation over the life of the securities.

As investors favored shorter-maturity debt as a haven, benchmark 10-year notes yielded about 40 basis points above two-year Treasuries, the most since June 2005.

“The safest trade we’ve been involved in has been” for the yield difference between the two maturities to increase, said Sean Murphy, a Treasury trader and strategist in New York at RBC Capital Markets, the investmentbanking arm of Canada’s biggest bank.

Yields on two-year notes exceeded those on 10-year notes, a situation known as an inverted yield curve, as recently as June 5. From June 2006 through June 2007 the yield curve was inverted 83% of the time.

International holdings of Treasuries increased by $54.3 billion in June, compared with a gain of $21.6 billion in May, the Treasury Department said yesterday.

Overall holdings of stocks, notes and bonds rose a net $120.9 billion, from $126 billion the previous month, the Treasury Department said in Washington. The increase was almost double the $63 billion median forecast in a Bloomberg News survey.

Merrill, in its report on Countrywide, raised the possibility of bankruptcy if the company loses access to short-term financing. Amber Cousins, a spokeswoman for Calabasas, Calif.-based Countrywide, didn’t return calls for comment.