Treasury debt prices climbed Thursday after signs of softness in manufacturing and the labor market hinted the economy continued to weaken.
The bond market, however, stuck to its newfound conviction that stubborn inflation pressures will force the Federal Reserve to start hiking rates by the end of the year.
That shift in bond investors' perceptions about the Federal Reserve has pushed up the two-year note's yield to four-month highs around 2.60 percent earlier this week.
The 2-year Treasury note's price was up 4/32 for a yield of 2.47 percent, versus 2.54 percent late Wednesday.
"Treasurys have gained because the the Empire State manufacturing report was actually down, while continuing claims rose," said Sean Murphy, Treasuries trader with RBC Capital Markets in New York.
Weekly initial jobless claims nearly matched economists' forecasts, but continuing claims, which economists often track more closely, were the highest since March 2004.
The New York Fed's Empire State manufacturing index, meanwhile, fell to a reading of -3.23 in May, below the consensus forecast for a flat reading. April industrial output fell 0.7 percent, weaker than economists' forecasts for a fall of 0.3 percent.
For Treasurys, "the crux of it all was that continuing claims were at a four-year high. That number is generally overlooked but is starting to get a little more noticed as things get worse," said Beth Malloy, bond market analyst with research company Briefing.com in Chicago.
Bonds have already priced in much of the deteriorating economic backdrop, and Treasurys gains were likely to be fleeting, traders said.
"If you look at the market from these levels ... positions are very defensive. There is no real fresh wave of buying coming in," Murphy said.
The benchmark 10-year Treasury note's price, which moves inversely to its yield, traded up 12/32 for a yield of 3.87 percent, still in sight of a four-month high above 3.98 percent hit on Wednesday.
Treasury yields have carved out new, higher ranges over the past two weeks as risk aversion associated with the credit crisis has started to ebb and investors have started to buy more stocks and non-government bonds.
Government bonds gradually extended gains after a Philadelphia Federal Reserve Bank survey showed that factory activity in the U.S. Mid-Atlantic region shrank for a sixth straight month in May, though not as sharply as expected.
Nonetheless, some fund managers are skeptical about the apparent easing of market fears because they expect that prolonged economic weakness may trigger fresh rounds of credit market stress.
A continued decline in home values, provided this is accompanied by ebbing inflation pressures, will ultimately force the Federal Reserve to cut rates again, some expect.
"In terms of the mortgage mess, if we continue to see minus 10 percent numbers in the Case Shiller (U.S. house price index) there will be a continued need to raise capital (by banks) and then the idea that the Fed will raise rates toward the end of the year will come off the table," said Charlie Smith, chief investment officer of Fort Pitt Capital Group in Greentree, Pa.
Federal Reserve Chairman Ben Bernanke on Thursday strongly urged financial institutions to remain proactive in capital-raising efforts, but initially Treasurys did not show much reaction.
The 30-year Treasury bond rose 13/32 in price for a yield of 4.59 percent.