TREASURIES-Iran attacks stoke inflation fears, two-year yield highest since August

By Karen Brettell

NEW YORK, March 12 (Reuters) - Two-year Treasury yields hit a six-month high on Thursday as Iran ramped up attacks on energy and transport targets in the Gulf, boosting oil prices and stoking concerns about resurgent inflation that could keep U.S. interest rates higher for longer.

Two fuel tankers were ablaze in an Iraqi port on Thursday after an apparent hit by explosive-laden Iranian boats on Wednesday, a step-up in attacks that have cut off oil from the Middle East.

"The inflationary and fiscal consequences of an extended war have left us wary of further weakness in Treasuries with no clear off-ramp to the conflict in sight," interest rate strategists at BMO Capital Markets said in a report.

Fed funds futures traders are pricing in 19 basis points of cuts by year-end, down from around 50 basis points a few weeks ago, indicating dwindling expectations that the Fed will be able to execute even one 25-basis-point cut this year.

Concerns over the impact from the Iran war have overshadowed economic data releases, including an unexpectedly weak payrolls report for February earlier this month.

If the war continues, traders say the market may start to price in more concerns about economic damage from persistently higher oil prices.

"If oil remains high enough then at some point it might be a hit to demand and disinflationary in that way," said Molly Brooks, U.S. rates strategist at TD Securities.

The two-year note US2YT=RR yield, which typically moves in step with Fed interest rate expectations, rose 11.3 basis points to 3.749%, the highest since August 22 and the biggest one-day yield increase since June.

The yield on benchmark U.S. 10-year notes US10YT=RR rose 4.9 basis points to 4.255%, the highest since February 5.

The yield curve between two- and 10-year notes US2US10=TWEB flattened by around 6 basis points, to 50 basis points. It earlier reached 49.4 basis points, the flattest since November 28.

Economists polled by Reuters continue to expect that the Fed will cut interest rates for the first time this year in June.

Treasuries showed little reaction to data on Thursday showing that the number of Americans filing new applications for jobless benefits fell last week.

A separate report showed that U.S. single-family homebuilding fell in January amid harsh winter weather and that a strong rebound is unlikely, with permits for future construction declining.

The Treasury drew good demand at a $22 billion sale of 30-year bonds on Thursday, the final sale of $119 billion in coupon-bearing supply this week.

The bonds sold at a high yield of 4.871%, around a basis point below where they traded before the auction. Demand was 2.45 times the amount of debt on offer.

The government saw soft demand for a $58 billion auction of three-year notes on Tuesday and a $39 billion sale of 10-year notes on Wednesday.