Two-year yields at three-month highs as consumer spending, inflation rise

Two-year U.S. Treasury yields hit three-and-a-half-month highs on Friday after data showed that U.S. consumer spending rebounded sharply in January amid strong income growth while inflation accelerated.

The data boosts expectations that the Federal Reserve will hike rates higher than previously expected and hold them in restrictive territory as it battles persistently high price pressures.

Consumer spending, which accounts for more than two-thirds of U.S. economic activity, jumped 1.8% last month. Economists polled by Reuters had forecast consumer spending rebounding 1.3%.

The personal consumption expenditures (PCE) price index also shot up 0.6% last month, after gaining 0.2% in December. In the 12 months through January, the PCE index was up 5.4%.

"This is increasing pressure on the Fed to keep going. They clearly have some work to do to slow the economy down and bring inflation back to 2%," said Priya Misra, head of global rates strategy at TD Securities in New York.

Other data showed that new home sales rose 7.2% in January, while a survey from the University of Michigan on Friday showed consumers' near-term inflation expectations increased in February.

Two-year yields (US2YT=RR), which are highly sensitive to Fed policy, rose as high as 4.840%, the highest since Nov. 4. Benchmark 10-year yields US10Y reached 3.978%, matching Thursday's high, which was the highest since Nov. 10.

The inversion in the yield curve between two-year and 10-year notes (US2US10=TWEB) deepened and was last at minus 86 basis points, reflecting concerns about an imminent recession.

The 10-year yields have risen from a four-month low of 3.321% on Jan. 19 as strong data and hawkish comments from Fed officials increase rate hike expectations.

Fed funds futures traders are pricing for the Fed's benchmark rate to peak at 5.40% in September, up from 4.58% now. (FEDWATCH), (USONFFE=)

The Fed is expected to raise rates by 25 basis points at its March 21-22 meeting, though some analysts see the possibility of a 50 basis points hike if inflation stays high and growth remains strong.

"That would be problematic for markets. It would scare markets, quite frankly, if they were to re-accelerate back to 50 basis points. I see 25 basis point moves, but potentially over a longer period of time," said Brendan Murphy, head of core fixed income for North America at Insight Investment in Boston.

The Fed pared back the pace of its rate increases to 25 basis points at its Jan. 31-Feb. 1 meeting after a year of larger hikes in order to better gauge the impact of its tightening.

February 24 Friday 3:00PM New York / 2000 GMT