TREASURIES-Two-year yields hit 16-month high on Fed rate hike bets

* Fed funds futures priced a 73% chance of a rate hike by September

* Bank of America now expects three Fed rate hikes this year

* The Treasury will auction $183 billion in coupon-bearing notes this week

By Karen Brettell

NEW YORK, June 22 (Reuters) - U.S. Treasury yields climbed on Monday, with interest-rate-sensitive 2-year yields touching a 16-month high, as traders positioned for a more hawkish Federal Reserve and the prospect of rate hikes later this year. The Fed last Wednesday held interest rates steady, but policymakers expect a hike in borrowing costs later this year amid growing concerns about inflation lodged above the U.S. central bank's 2% target.

"The biggest driver in the market right now is a pretty dramatic hawkish shift in expectations after hearing from Warsh and looking at the change in the dot plot last week," said Zachary Griffiths, head of investment-grade and macro strategy at CreditSights.

In an early sign of new Fed Chairman Kevin Warsh's influence, the Fed's statement last week was also stripped of any forward guidance on future rate moves and simply stated the rate decision and reaffirmed the Fed's commitment to maintaining "ample reserves in the banking system." Bank of America now expects three Fed rate hikes this year, reversing its prior forecast of no change.

Fed funds futures traders are pricing in 73% odds of a rate hike by September.

The 2-year note yield, which typically moves in step with Fed interest rate expectations, rose 3.61 basis points to 4.215% and reached 4.236%, the highest since February 2025.

The yield on benchmark U.S. 10-year notes rose 4.19 basis points to 4.493%.

The yield curve between two- and 10-year notes steepened to 28 basis points, after reaching 24.2 basis points on Thursday, the flattest level since March 2025.

The stark move in the yield curve, which reflects two-year yields rising much faster than longer-dated yields since the Fed meeting, may suggest that investors in the longer maturities are more comfortable with the risk of higher rates, said Griffiths.

"It indicates that maybe the long end of the market is comfortable and even happy with a Fed that perhaps stands ready to fight inflation should it need to, versus concerns that Warsh would come in and deliver rate cuts," Griffiths said.

Meanwhile, with less guidance to anchor expectations, analysts warn that market reactions to economic data could become more volatile, as traders scrutinize each release for clues about the Fed's next move.

"A Greenspan toolkit - short statement, little guidance, small balance sheet - means a noisier front end and a more volatile curve shape, even at a flat level," Morgan Stanley analysts led by Matthew Hornbach said in a report.

The highlight of this week's U.S. economic calendar will be the PCE inflation report on Thursday. Core prices are expected to have risen 0.3% in May, putting the annual rate at 3.4%, while headline inflation is forecast at 0.5% for the month and 4.0% year-over-year. Traders are also keeping a close eye on diplomatic efforts to end the conflict with Iran. The U.S. and Iran made "encouraging progress" at the first round of talks aimed at reaching a final peace deal, mediators said on Monday, although tension persisted over Lebanon and the Strait of Hormuz.

Oil prices have eased as negotiations advance, though analysts note it could take months for any relief to filter through to U.S. consumer prices.

On the supply front, the Treasury will auction $183 billion in short- and intermediate-term coupon-bearing notes this week. This will include $69 billion in two-year notes on Tuesday, $70 billion in five-year notes on Wednesday, and $44 billion in seven-year notes on Thursday.

(Reporting by Karen Brettell; Editing by Andrea Ricci )