Yields fall as investors ramp up Fed cut bets on US banking jitters

SINGAPORE, Oct 17 (Reuters) - Short-term U.S. Treasury yields hit multi-year lows on Friday as growing signs of credit stress in the U.S. banking system prompted nervous investors to price in more aggressive Federal Reserve rate cuts this year and next.

Markets were once again on edge after U.S. bank Zions Bancorporation ZION.O said overnight it would take a $50 million loss in the third quarter on two loans from its California division, sending its shares tumbling 13%.

Western Alliance's WAL.N stock slumped 11% after it initiated a lawsuit alleging fraud by Cantor Group V, LLC.

The developments left investors scooping up safe-haven assets and betting that the Fed will ride to the rescue by delivering a series of interest rate cuts to ease the strain on markets.

The two-year Treasury yield US2YT=RR, which typically reflects near-term rate expectations, hit a more than three-year low of 3.3890% in the Asian session, while the five-year yield US5YT=RR slid 4 basis points to hit a one-year trough of 3.5100%.

Investors are now pricing in a roughly 5% chance the Fed could lower rates by an outsized 50 bps later this month, up from none a day ago, according to the CME FedWatch tool.

Fed funds futures have also added another 5 bps worth of cuts by August next year. 0#USDIRPR

"The banks involved seem relatively small and the volume of loans that are involved seem relatively small as well. So I do think perhaps the market has got a little bit unnecessarily worried on that front. But... it just adds to all of the concerns that we've been talking about for the last week or so," said Michael Brown, senior research strategist at Pepperstone.

Markets have had a whirlwind week dominated by mounting trade tensions between the U.S. and China.

Further out the curve, the yield on the benchmark 10-year U.S. Treasury note US10YT=RR similarly sank to a six-month trough of 3.9380%. The 30-year yield fell roughly 3 bps to 4.5490%, also its lowest in six-months.

Investors had already been gunning for more rate cuts from the Fed after Chair Jerome Powell earlier this week left the door open to further easing and said the end of the central bank's long-running effort to shrink the size of its holdings may be coming into view.

"The Fed have already effectively told us that they are going to end balance sheet runoff sooner rather than later. Obviously, if we see further signs of stress in funding markets, then that sooner is going to be very, very soon indeed," said Brown.