June 7 (Bloomberg) -- The benchmark 10-year U.S. Treasury note fell the most in more than three years after New Zealand unexpectedly raised interest rates, igniting concern other central banks will respond to faster global growth.

Interest-rate futures and options showed traders who as recently as December were betting on three quarter-percentage point rate cuts by the Federal Reserve this year boosted bets on an increase in borrowing costs. The tumble pushed 10-year yields above 5 percent for the first time since August.

``This may prove to be the capitulation trade,'' said Michael Materasso, co-chair of the fixed-income policy committee at Franklin Templeton Investments, which oversees $128 billion of bonds. ``A month and a half ago, investors were expecting the Fed to cut rates'' by October.

The 10-year Treasury yield rose 17 basis points, or 0.17 percentage point, to 5.13 percent at 5:19 p.m. in New York, the highest since July 19, according to bond broker Cantor Fitzgerald LP. The increase is the biggest since an identical gain on May 7, 2004. Yields move inversely to bond prices. The price of 4 1/2 percent notes maturing in May 2017 fell 1 9/32, or $12.81 per $1,000 face amount, to 95 3/32.

About $529 billion changed hands through ICAP Plc, the world's largest broker of trades between banks, as of 4 p.m. New York time, more than double the three-month daily average of $262 billion. The total was the largest since $588 billion on Feb. 28.

Stocks also tumbled with the Standard & Poor's 500 Index declining 1.8 percent.

Fed's Target

The Fed's target for the overnight lending rate between banks is likely to hold at 5.25 percent through February, yields on federal funds futures show. The yield on the December contract rose 2 basis points to 5.23 percent, the highest since Aug. 15. The yield is up from the low over the past year of 4.44 percent on Dec. 1.

Options on the fed funds rate show that as of yesterday, the odds of an increase to 5.50 percent were almost 41 percent. A month earlier, the odds were zero.

Ten-year yields now exceed those on two-year securities by 10 basis points, the most since May 2006, on speculation investors are likely to demand compensation for the risk that alternative investments will provide greater returns over time. Three days ago, it was 3 basis points lower than two-year yields.

For most of the past two years, long-maturity Treasury yields have been even with or lower than short-maturity yields in spite of 17 quarter-percentage point increases in the Fed's target for the overnight lending rate between banks. In February 2005, then-Fed Chairman Alan Greenspan called the behavior of 10- year yields ``a conundrum'' partly attributable to purchases by foreign governments.

`Great Conundrum'

``The great conundrum that Chairman Greenspan spoke about many years ago, driven by global reserves recycling into U.S. Treasuries, is unwinding, leading to higher long yields and steeper curves,'' said Brian Varga, head of U.S. Treasury trading at Countrywide Securities Corp. in Calabasas, California. ``Yields are competing for capital with equities and other riskier asset classes.''

Yields on inflation-protected Treasuries also rose, indicating that expectations of faster economic growth, rather than accelerating inflation, were the main reason for the sell- off. Inflation-protected securities pay interest at lower rates than regular Treasuries on a principal amount that's adjusted for inflation.

Inflation-Protected Treasuries

The yield on 10-year inflation-protected Treasuries rose 11 basis points to 2.69 percent, the highest since August 2002. The gap between its yield and the comparable nominal yield, the expected inflation rate over the life of the notes, increased to 2.46 percent. It's been as high as 2.66 percent in the past year.

``This does not seem to be about inflation,'' said Daniel Shackelford, part of a group that manages $12 billion of bonds at T. Rowe Price Group Inc. in Baltimore.

Other government bond markets also fell as traders added to bets that short-term interest rates controlled by central banks will either rise further or hold for longer than previously forecast. A surge in employment growth in Australia was another catalyst for the move, which pushed Japanese 10-year yields to the highest since August and German 10-year yields to the highest since December 2002.

New Zealand's central bank raised its benchmark interest rate a quarter-percentage point to 8 percent today, saying housing demand and consumer spending are fanning inflation. In Australia, traders increased the probability of an August rate increase to 64 percent from 50 percent, and completely priced one in by October.

Expectations for additional rate increases by the European Central Bank and the Bank of England also increased.

`New Zealand Move'

``Investors took fright at the New Zealand move,'' said Stuart Thomson, who manages 23 billion pounds ($45.5 billion) in bonds at Resolution Investment Management Ltd. in Glasgow, Scotland. ``Global growth is too strong; yields have to rise. The trend is bearish.''

Mortgage servicers, who collect payments on the loans, helped drive the slump in Treasury prices and a widening of yield spreads between interest-rate swaps and similar-maturity government debt, Walter Schmidt, a structured-product strategist in Chicago at FTN Financial Capital Markets, said.

To offset the possibility of the value of their servicing contracts declining if rates were to fall and refinancings increase, shortening the contracts' lives, servicers often buy Treasuries and swaps, which would rise in value in such a scenario, he said.

``When you have a sell-off like this, and you're a servicer, you're basically unwinding your hedges,'' he said.

The 10-year interest-rate swap spread increased almost 4 basis points to 60 basis points, the widest since July 19.

The drop in Treasuries may slow on speculation declines in stocks will increase the appeal of bonds. The three-day fall in the S&P 500 Index was 3.1 percent.

``At around 5 percent, 10-year Treasuries are not looking expensive,'' said Michael Thomas, head of economics and strategy at ICAP Australia Ltd. in Sydney.

To contact the reporter on this story: Elizabeth Stanton in New York at estanton@bloomberg.net

Last Updated: June 7, 2007 17:22 EDT