By Herbert Lash

NEW YORK (Reuters) -The yield on two-year U.S. Treasury notes, a rough gauge of interest rate expectations, rose to almost a 15-year high on Tuesday, a day before the Federal Reserve is likely to hike rates by 75 basis points as it fights surging inflation.

The two-year is highly sensitive to shifts in monetary policy expectations and early Tuesday it hit 3.992%. The last time its yield broke above 4% was Oct. 18, 2007.

The Fed will announce its latest policy decision on Wednesday. Money markets are fully pricing in a 75 basis point rate hike, with the chance of a larger full-point rate hike fading to just 16%, according to CME’s FedWatch tool.

Sweden’s central bank earlier raised rates by a larger-than-expected full percentage point to 1.75% and warned of more to come as it joins other central banks around the world that also are jacking up rates to tame inflation.

Fed Chair Jerome Powell will stand by his hawkish stance and desist offering a moderate tone that has driven recent post-meeting rallies, said Johan Grahn, head of ETF strategy at AllianzIM.

“I don’t think you’re going to see even a single dovish feather. He’s tried that a couple of times and then he gets the exact opposite from the market,” Grahn said.

Yields on the benchmark 10-year Treasury shot to 3.604% before paring some gains. They were up 8 basis points to 3.569% after topping 3.5% for the first time in 11 years on Monday. The two-year yield rose 1.2 basis points to 3.958%.

The 10-year moving higher and faster than the two-year could be positioning ahead of tomorrow’s Fed statement or it could be the Riksbank raising rates more than expected, said Lawrence Gillum, fixed income strategist at LPL Financial.

“What’s happening for the Fed and other central banks is there’s a push to front-load these rate hikes,” Gillum said.

“There’s a lot of jitters and some pre-positioning that’s going into tomorrow’s meeting,” he said. “Foreign rates moving higher, that makes our rates less attractive.”

The closely watched gap between two- and 10-year yields earlier reached a discount of as much as -47.5 basis points, approaching its most negative since Aug. 10 when the discount widened to -56.2 basis points. The gap later narrowed to -39.1 basis points.

The two- and 10-year yield inversion, when the short end is higher than the long end, often has been seen as a reliable predictor of a recession in a year or two.

After the Fed statement on Wednesday the market will try to gauge whether the U.S. central bank will raise rates by 50 basis points in November, said Anthony Saglimbene, chief market strategist at Ameriprise Financial in Troy, Michigan.

“I don’t think they’re going to communicate that, but I think the market will try to anticipate that and if they do, then you could see over the coming months some equilibrium level in rates,” Saglimbene said.

“The terminal rate at which the Fed will stop raising interest rates is higher, and that terminal rate is likely to last longer,” he said. “All of it is centered around inflation pressures that are more persistent.”

Rates are rising and setting new milestones. The breakeven rate on five- and 10-year Treasury Inflation-Protected Securities, or TIPS, have surged to 13- and 12-year highs, respectively.

The five-year TIPS breakeven rate was last at 2.532%, while the 10-year TIPS breakeven rate was last at 2.39%. The latter indicates the market sees inflation averaging about 2.4% a year for the next decade.

The yield on the 30-year Treasury bond rose 7.4 basis points to 3.579%.

The U.S. dollar five years forward inflation-linked swap, seen by some as a better gauge of inflation expectations due to possible distortions caused by the Fed’s quantitative easing, was last at 2.413%.

Sept. 20 Tuesday 2:57 PM New York / 1857 GMT

Price Current Net

Yield % Change

(bps)

Three-month bills 3.2625 3.3356 0.034

Six-month bills 3.775 3.9021 0.024

Two-year note 98-175/256 3.9601 0.014

Three-year note 98-204/256 3.9311 0.031

Five-year note 97-54/256 3.7482 0.055

Seven-year note 96-140/256 3.6932 0.076

10-year note 93-56/256 3.5689 0.080

20-year bond 93-132/256 3.844 0.071

30-year bond 89-104/256 3.5799 0.075

DOLLAR SWAP SPREADS

Last (bps) Net

Change

(bps)

U.S. 2-year dollar swap 37.75 1.00

spread

U.S. 3-year dollar swap 18.00 0.75

spread

U.S. 5-year dollar swap 8.75 0.50

spread

U.S. 10-year dollar swap 6.50 -0.25

spread

U.S. 30-year dollar swap -30.75 -1.25

spread

(Reporting by Herbert Lash, additional reporting by Samuel Indyk in London; Editing by Nick Zieminski)

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