(Bloomberg) -- Treasuries fell, with two-year note yields rising to the highest in almost three weeks, as data showing expansion in the U.S. manufacturing sector fueled wagers that the Federal Reserve will raise interest rates before year-end.
A gauge of the yield curve flattened for the first time in four days as short-dated notes led losses after the Institute for Supply Management's manufacturing index increased to 51.5 in September following an unexpected contraction in August. The probability of a rate hike by December climbed to 60 percent, according to futures data compiled by Bloomberg, the highest since Sept. 21.
"The ISM number was actually quite solid, suggesting that the slip last month was not sustained," said Gennadiy Goldberg, an interest-rate strategist in New York at TD Securities (USA) LLC, one of 23 primary dealers that trade with the Fed. "You're seeing the nominal curve bear flatten as the market prices in higher odds of a December rate hike."
Treasuries have gained about 5 percent this year as the Fed has held off on raising rates. Officials said at their Sept. 21 meeting that the case to hike had strengthened amid improving U.S. economic data. Three members of the policy-setting committee dissented in favor of raising rates at that meeting, including Cleveland Fed President Loretta Mester, who said Monday that the Fed's November meeting should be viewed as "live" for a policy decision.
Break-Even Rate
Two-year yields rose three basis points, or 0.03 percentage point, to 0.79 percent as of 5 p.m. in New York, according to Bloomberg Bond Trader data, the highest closing level since Sept. 13. The price of the 0.75 percent security due in September 2018 was 99 29/32. U.S. 10-year yields rose three basis points to 1.62 percent.
The gap between two- and 30-year yields fell to about 1.55 percentage points.
Futures imply about a 60 percent chance of a quarter-point boost by year-end, according to data compiled by Bloomberg, up from about 50 percent a week ago. The calculation assumes the effective fed funds rate trades at the middle of the new target range after the next hike.
“I would expect that the case would remain compelling” for a hike when officials gather in Washington Nov. 1-2, the week before Americans head to the polls, Mester said in an interview with Bloomberg Television.
The ISM data come as U.S. 10-year break-even rate, a measure of investors' inflation expectations, climbed to the highest since May. The gauge surged after OPEC on Sept. 28 announced an agreement to limit production for the first time in eight years, sending oil prices near a three-month high.
Investors have increased their appetite for Treasury Inflation-Protected Securities, or TIPS, as Jeffrey Gundlach and Goldman Sachs warned that higher inflation is coming. The Treasury Department's $11 billion sale of 10-year TIPS on Sept. 22 drew the highest demand at an auction of the securities in more than two years. Data last week showed the Federal Reserve's preferred gauge of inflation rose more than forecast in August.
"If core inflation is stirring and then you have an OPEC deal that hints at higher oil prices, then it sets up a positive environment for TIPS," Goldberg said.
--With assistance from Christopher Condon To contact the reporters on this story: Rebecca Spalding in New York at rspalding@bloomberg.net, Yun Li in New York at yli934@bloomberg.net. To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Michael Aneiro
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