NEW YORK (Reuters) - Fears about the Federal Reserve buying fewer bonds later this year pummeled the U.S. bond market on Thursday, pushing benchmark yields to the highest levels since August 2011, with few signs of when the month-long rout will end.
The sell-off in U.S. government debt has been swift and dramatic. The iShares Barclays 20-year-plus exchange-traded fund (TLT.P), one of the most popular bond ETFs, has lost about 10.7 percent during this period - comparable to a 1,500 point drop in the Dow Jones industrial average .DJI.
The surge in bond yields, should it continue, could hamper the economic recovery the Fed is counting on to exit from the unprecedented stimulus it has injected into the banking system for over four years to grapple with the global credit crisis.
"We are in a regime shift in interest rates. The longer-term shift in interest rates is higher," said Stephen Sachs, head of capital markets with ProShare Advisors LLC in Bethesda, Maryland.
The sell-off comes amid signs of tightening in other credit markets, notably China, where the cost for banks to borrow from one another hit record highs overnight.
The 10-year Treasury note's yield rose to 2.42 percent on Thursday - highest since August 2011. Treasury yields are benchmarks for mortgage rates and other long-term borrowing costs.
This sudden leap in yields has raised worries that it will unravel the housing rebound which has shown signs of gaining traction, as sales of existing U.S. homes hit a three-and-a-half year high in May, data released Thursday showed.
Anxiety about the end of near-interest-free money from the Federal Reserve coming sooner than some traders had expected was confirmed on Wednesday when Fed chief Ben Bernanke laid out the blueprint for how and when the central bank will pare its $85 billion monthly purchases of Treasuries and mortgage-backed securities.
The surge in yields has roiled other credit markets here and abroad. The turmoil brought new issuance to a halt in both investment-grade and junk bonds, with investors and issuers alike wary of the sharp spike in Treasury yields.
Perceptions in the market started to shift almost a month ago when Bernanke broached the idea of reduced purchases.
The bond market selloff has been intense, with heavy trading from a broad spectrum of investors from hedge funds to large fund managers, and it has boosted mortgage rates to levels not seen in a year. The TLT ETF saw its busiest day of trading since May 2012, with more than 24 million shares traded by 3:30 p.m. (1930 GMT).
Recent data that shown inflation falling below the Fed's 2 percent target, raising speculation that the signal from the Fed on buying fewer bonds was premature, but Bernanke downplayed these concerns at Wednesday's press conference.
The reaction in markets shows a re-appraisal of the inflation outlook. Investors are more concerned now about falling inflation rates, judging by the poor bidding at a $7 billion auction of 30-year Treasury Inflation-Protected Securities on Thursday.
Inflation expectations as measured by the yield differential between the nominal 10-year yield and the yield on 10-year Treasury Inflation Protected Securities (TIPS) has fallen to 1.98 percent, lowest since December 2011.
The Federal Open Market Committee, the Fed's policy-setting group, offered a mild upgrade on the economy in its policy statement after its two-day meeting on Wednesday, and Bernanke's remarks at a press conference laid out the Fed's plans to cut purchases soon.
Bernanke drew a distinction between less stimulus through buying fewer bonds and tightening monetary policy via hiking interest rates. That's a distinction the bond market does not necessarily agree with, economists said.
"The reaction in markets to the Fed reflects the disconnect over stock versus flow - the Fed likes to believe according to its simplistic models that tapering isn't tightening, but of course it is," said Julia Coronado, chief economist, North America, at BNP Paribas.
The FOMC repeated that it will not raise interest rates until unemployment hits 6.5 percent or lower, provided that the outlook for inflation stays under 2.5 percent. The jobless rate was 7.6 percent in May.
On the open market, the benchmark 10-year Treasury note fell 12/32 point in price to 94-9/32, with a yield of 2.401 percent, about 5 basis points up from late on Wednesday. At one point the 10-year yield touched 2.471 percent, the highest intraday level since August 2011, according to Reuters.
The 30-year bond was the day's worst performer. The longest U.S. government debt maturity at one point down more than 2 points in price with its yield climbing to 3.548 percent, its highest level in about 22 months.
The iShares iBoxx Investment Corporate Bond Fund, a popular ETF, has lost 2.5 percent in two days to hit a 14-month low.
Additional reporting by Karen Brettell, John Balassi, Natalie Harrison and IFR team; Editing by Kenneth Barry