June 10 (Bloomberg) -- Treasuries slumped, driving two-year yields up the most in two days in at least 20 years, after Federal Reserve Chairman Ben S. Bernanke pledged to ``strongly resist'' any waning of public confidence in stable prices.

Two-year note yields increased following comments by Bernanke after U.S. trading closed yesterday that the risk of a ``substantial downturn'' in U.S. economic growth has diminished. Traders now see an 86 percent probability that policy makers will raise interest rates by at least a quarter-percentage point in September, futures showed.

``The market certainly believes the next move is a tightening regardless of what the economic data is,'' said Charles Comiskey, co-head of U.S. Treasury trading in New York at HSBC Securities USA Inc., one of 20 primary dealers that trade with the Fed.

The two-year note's yield rose 18 basis points, or 0.18 percentage point, to 2.89 percent at 3:39 p.m. in New York, according to BGCantor Market Data. It touched 2.95 percent, the highest since it reached 3.10 percent on Jan. 2. The price of the 2.625 percent security due in May 2010 fell 11/32, or $3.44 per $1,000 face amount, to 99 1/2. The 10-year yield climbed 10 basis points to 4.10 percent.

Yields on two-year notes have advanced this week by 51 basis points, the biggest two-day jump as far back as Bloomberg data goes. They rose yesterday by 33 basis points, the most in a single day since March 1996, when they gained 36 basis points as faster-than-expected job growth dimmed rate-cut prospects.

The difference in yield, or spread, between two- and 10- year notes narrowed today to 121 basis points. The gap was as wide as 208 basis points in March.

`Stand Pat on 10-Year'

``I would probably stand pat on the 10-year for quite some time,'' said Daniel Fuss, Boston-based vice chairman of Loomis Sayles & Co., who oversees $22 billion. ``The various steepening and flattening trades will whipsaw people.''

Futures on the Chicago Board of Trade show investors are betting on an increase in the Fed's 2 percent target rate for overnight lending between banks in September. The odds of an increase of at least a quarter-percentage point are more than four times the 19 percent likelihood seen a week ago.

``People are hyper-concerned about anything that illustrates that the Fed is going to raise rates, even if the economy remains slow,'' said Jim Vogel, head of agency debt research at FTN Financial Group in Memphis, Tennessee.

Bernanke said yesterday in his speech to a Boston Fed conference that the risk of a major drop for the economy ``appears to have diminished over the past month or so.'' The central bank ``will strongly resist an erosion of longer-term inflation expectations,'' he said.

Seeking Balance

The Fed chairman used ``somewhat stronger language than usual,'' Goldman Sachs Group Inc., the biggest securities company in the U.S., said in a report to clients. Fed officials have cut their benchmark lending rate from 5.25 percent in September to keep a U.S. housing recession and losses from the credit markets from driving the economy into a recession.

``They got to a point where they felt comfortable with the liquidity that they're providing, and rates are low enough to stimulate something that they don't want, which is inflation, so they're trying to balance that out,'' said George Goncalves, chief Treasury and agency strategist with Morgan Stanley, a primary dealer. ``This is the next area of discussion that the Fed's going to focus on, as long as we don't have another bank meltdown.''

Treasuries extended their losses after the Bank of Canada unexpectedly kept its benchmark interest rate unchanged on concern energy costs may push inflation past the top of its target band later this year. Economists in a Bloomberg News survey had forecast a quarter-percentage point reduction.

`Ridiculously Cheap'

The slump in Treasuries surprised economists, who predicted two-year yields would end this month at 2.35 percent, according to the median of 48 estimates in another Bloomberg survey.

``The short end of the Treasury curve is probably ridiculously cheap right now,'' said Maxwell Bublitz, chief strategist in San Francisco at SCM Advisors LLC, which oversees about $12 billion in fixed-income assets.

U.S. government securities have handed investors a loss of 3.3 percent since yields began rising during the third week of March, according to a U.S. Treasury master index compiled by Merrill Lynch & Co. Japanese bonds lost 2 percent, while the decline was 3.4 percent in Germany.

Treasuries underperformed European government notes. The yield spread between the two-year Treasury and the equivalent German benchmark note narrowed to 180 basis points, from 198 basis points yesterday.

Some Say `Overdone'

``Some investors view the move as overdone,'' said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., a primary dealer. ``As much as the Fed is concerned about inflation and inflation expectations, they also do remain concerned about the overall economic backdrop as well as liquidity in the banking system.''

Traders' expectations of inflation over the next decade have risen as oil and commodity prices surged. The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes widened to 2.52 percentage points, from 2.45 percentage points a week ago and 2.28 percentage points at the end of April.

U.S. consumer prices rose 3.9 percent in May from a year earlier, the same as in April, according to a Bloomberg News survey of economists before the Labor Department reports the figure on June 13.

That means 10-year notes yield just 20 basis points after inflation is considered, and shorter maturities don't yield enough to keep up with quickening prices for goods and services. The average gap between the 10-year yield and the inflation rate over the past 10 years is 203 basis points.

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Sandra Hernandez in New York at shernandez4@bloomberg.net

Last Updated: June 10, 2008 15:42 EDT