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TREASURIES-U.S. yields surge after CPI surprises to upside in August

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(Adds bond auction data, comment, fresh prices) By Herbert Lash NEW YORK, Sept 13 (Reuters) - U.S. Treasury yields surged and a recession warning - the yield curve inversion - widened on Tuesday after monthly U.S consumer prices unexpectedly rose in August, signaling to the market that the Federal Reserve will crack down further on inflation. The yield on two-year Treasury notes, which typically reflects interest rate expectations, spiked to a fresh 14-year high of 3.783% in a move that significantly widened the yield curve gap with the benchmark 10-year Treasury note. Market rates were declining before the consumer price report on expectations headline inflation had peaked and that even though Fed policymakers were expected to hike rates another 75 basis points next week, they would soon pull back. The consumer price index rose 0.1% last month after being unchanged in July, while the CPI edged up 8.3% in the 12 months through August. Economists polled by Reuters had forecast the monthly CPI dipping 0.1% and year-over-year rising 8.1%. "Inflation is public enemy No. 1 for the Fed, and I think this number puts pressure on them to continue," said Priya Misra, head of global rates strategy at TD Securities. "We get a fairly hawkish message out of that September Fed meeting, and that's what the market is pricing in if you look at today's massive move higher in rates," Misra said. The Fed's terminal rate could rise to the mid-4% range before rates start declining, she said. The market before Tuesday had expected that rate to top around 3.75% if not lower. Nomura said in a note it expects a terminal rate of 4.50%-4.75% by February. Fed fund futures priced in a 25% chance that the Fed will raise rates by 100 basis points (bps) at the end of the Fed's two-day meeting Sept. 20-21. Misra doubted the Fed would go that high, but said 75 bps in November was possible. "It really comes down to how sticky inflation remains," said Mauricio Agudelo, senior fixed income portfolio manager at Homestead Funds Advisers. "It's a battle that the Fed will continue to fight and they will have to continue pressing, unfortunately at the risk of breaking something." The longer inflation remains elevated, terminal rate expectations will likely slide higher, said Chip Hughey, managing director of fixed income at Truist Advisory Services. "The only meaningful deflationary piece was gasoline. So you really had broad inflationary pressures continuing to a more significant degree than what the market is expecting," he said. The yield on 10-year Treasury notes rose 5.9 basis points to 3.422%, while the gap between yields on two- and 10-year notes, seen as a recession harbinger, widened to -33.6 basis points from -21.6 late on Monday. "The curve can be even more inverted, because the front end keeps moving higher due to inflation," Misra said. "But the economy’s ability to handle the rate hikes, we haven’t become more resilient on that front." The Treasury's auction of $18 billion in 30-year bonds was quite strong, said Lou Brien, market strategist at DRW Trading, in a note. The yield at 3.511% was almost two full basis points less than market bidding at the sale's deadline, he said. The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.617%. The 10-year TIPS breakeven rate was last at 2.44%, indicating the market sees inflation averaging about 2.5%% a year for the next decade. The U.S. dollar 5 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 2.422%. September 13 Tuesday 1:34PM New York / 1734 GMT Price Current Net Yield % Change (bps) Three-month bills 3.18 3.2506 0.099 Six-month bills 3.6575 3.7782 0.192 Two-year note 99-13/256 3.756 0.185 Three-year note 99-72/256 3.7556 0.157 Five-year note 97-234/256 3.5875 0.130 Seven-year note 97-130/256 3.5318 0.096 10-year note 94-100/256 3.4215 0.059 20-year bond 94-152/256 3.763 0.009 30-year bond 90-156/256 3.5094 -0.004 DOLLAR SWAP SPREADS Last (bps) Net Change (bps) U.S. 2-year dollar swap 34.25 1.25 spread U.S. 3-year dollar swap 12.75 2.50 spread U.S. 5-year dollar swap 4.75 -0.75 spread U.S. 10-year dollar swap 6.00 -0.50 spread U.S. 30-year dollar swap -32.00 0.25 spread (Reporting by Herbert Lash, additional reporting by Gertrude Chavez-Dreyfuss in New York; Editing by Jonathan Oatis and Nick Zieminski)