Investors flee 2-year Treasuries on inflation shock

SINGAPORE, June 13 (Reuters) – Short-dated US Treasuries dropped sharply in Asia on Monday as investors scrambled to price in an even steeper rate-hike path to tame inflation and worried that rapidly tightening financial conditions could severely dent the world’s biggest economy.

Two-year Treasury yields rose as far as 12.7 basis points (bps) to 3.1940%, the highest level since late 2007, extending selling after Friday’s hot inflation data. A holiday in Australia thinned trade and liquidity a little.

The flight from the short end leaves the two year yield up nearly 40 bps in two sessions and has futures pricing pointing to the Federal Reserve’s benchmark funds rate hitting 3% before the year’s end and topping 3.8% before the middle of 2023.

“There was a view that CPI had peaked. The numbers on Friday showed that it hasn’t peaked,” said Mitul Kotecha, a strategist at TD Securities in Singapore.

“There’s a realisation that the Fed is going to have to do more and put its foot on the pedal even more aggressively,” he said. “There is a risk that pushes the US and global economy into recession.”

That fear was reflected in a relatively steady 10-year yield at 3.1874%, narrowing the gap on the two-year yield to just 1.8 bps in a signal that investors expect the looming short-term hikes will hurt longer term growth.

Soaring food and energy prices drove the largest year-on-year gain in US consumer prices since 1981 last month, against an expectation for inflation to begin slowing down.

“We think the Fed probably wants to surprise markets to re-establish its inflation fighting credentials,” Barclays analysts said in a Sunday note, forecasting a 75-bp hike this week.

CME’s FedWatch tool showed a roughly 1/4 chance of a 75-bp hike when the Fed meets on Wednesday, which would be the biggest single-meeting hike since 1994.

Fed funds futures 0#FF: fell heavily on Monday, especially contracts for the early months of next year, to show markets pricing the Fed’s benchmark rate around 3.8% by May next year.

The selling also set other markets on edge, knocking S&P 500 futures ESc1 1.5% lower and lifting the US dollar to its strongest level on the yen since 1998.

(Reporting by Tom Westbrook; Editing by Shri Navaratnam)