TREASURIES-U.S. yields rise as Fed policy decision in focus

* Still about four hikes priced in fed funds futures market * Investors focused on Fed's balance sheet strategy * U.S. Treasury's 5-year note auction shows strong demand (Adds new comment, updates prices) By Gertrude Chavez-Dreyfuss NEW YORK, Jan 25 (Reuters) - U.S. Treasury yields on 2-year notes and higher rose on Tuesday, a day before a Federal Reserve statement that is likely to signal a rate increase in March, tightening policy for the first time since it cut borrowing costs to near-zero soon after the start of the pandemic nearly two years ago. The yield curve flattened on the day, with the spread between U.S. 2-year and 10-year yields narrowing to 74 basis points, as investors prepared for incoming rate hikes that should push short-term rates higher. A strong U.S. 5-year Treasuries auction briefly pared losses in the note's price, pushing yields lower. Investors, however, remained squarely focused on the Fed, which will issue its policy statement at 2 p.m. ET (1900 GMT) Wednesday, at the close of its two-day meeting. The big question for investors will be the Fed's strategy and time frame on shrinking its roughly $9 trillion balance sheet, as it moves from buying bonds, known as quantitative easing (QE), to quantitative tightening (QT). "We look for the swift shift from QE to QT to push up 10-year term premia which have been uncharacteristically low," Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, told the Reuters Global Markets Forum. "That along with expectations of further rate hikes through 2023 at least, the 10-year yield should end Q1 around 1.85%. Along the way, long-term bond volatility will remain high reflecting the volatility in the equity market and safe-haven flows," she added. Fed funds futures have fully priced in a quarter-point tightening for the Fed's March meeting, plus about three more for 2022. U.S. stock markets closed lower on Tuesday in volatile trading on nervousness about how aggressive the Fed intends to be in its Wednesday statement and the press briefing with Fed Chair Jerome Powell. Some market participants suggested that given the volatility in U.S. equities, the Fed could potentially pull back from the hawkishness evident after its December meeting and the minutes of that gathering released earlier this month. In late afternoon trading, the benchmark U.S. 10-year yield rose 5 basis points to 1.7867%. "We are relatively bullish on Treasuries, and when I say relatively, we'll end up at 2% or slightly higher on the 10-year note," said Jay Hatfield, chief investment officer at Infrastructure Capital Advisors, in New York. "If that's the case, the 10-year is at roughly between 1.77% to 1.78%, which means that we have already done a lot of the damage. We think that the December Fed minutes were perceived by the market as more hawkish than the committee actually was," he added. U.S. 30-year yields were up nearly 4 basis points to 2.1235%. On the shorter end of the curve, U.S. Treasury 2-year and 5-year yields rose to 1.0313% and 1.5674%, respectively. Both maturities reflect the market's interest rate expectations. A robust auction of the Treasury's $55 billion in U.S. 5-year notes briefly push yields lower. The 5-year cleared at a high yield of 1.533%, well below the expected rate at the bid deadline of 1.549%, suggesting strong demand. The bid-to-cover ratio, another gauge of demand, was 2.50, higher than the 2.41 in December and the 2.37 average. Indirect bidders, which include foreign central banks, were awarded 68.7% of the total, the largest since September 2017, according to Action Economics. In the U.S. high-yield market, the ICE BofA U.S. high-yield index showed credit spreads widened to 344 basis points on Monday, the widest since early December, and suggests increasing nervousness ahead of the Fed statement and press briefing on Wednesday. January 25 Tuesday 4:19PM New York / 2119 GMT Price Current Net Yield % Change (bps) Three-month bills 0.19 0.1927 0.000 Six-month bills 0.3875 0.3937 0.013 Two-year note 99-177/256 1.0313 0.044 Three-year note 99-144/256 1.2756 0.044 Five-year note 98-126/256 1.5691 0.055 Seven-year note 97-180/256 1.7281 0.046 10-year note 96-92/256 1.7814 0.046 20-year bond 97-12/256 2.1844 0.037 30-year bond 94-124/256 2.1257 0.041 DOLLAR SWAP SPREADS Last (bps) Net Change (bps) U.S. 2-year dollar swap 13.75 -3.50 spread U.S. 3-year dollar swap 13.75 0.00 spread U.S. 5-year dollar swap 7.25 -0.50 spread U.S. 10-year dollar swap 5.75 0.00 spread U.S. 30-year dollar swap -18.25 0.25 spread (Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Lisa Mattackal; Editing by Marguerita Choy, Leslie Adler and Aurora Ellis)