TREASURIES-Bonds tumble as jobs data ignite rate-hike fear

* Renewed mortgage-related sales intensify market drop

* Two-year yield posts biggest 1-day rise since Sept

* Ten-year yield registers biggest weekly jump in 6 years

* Yield curve steepens to record, then flattens (Recasts lead, updates prices, changes byline)

By Richard Leong

NEW YORK, June 5 (Reuters) - A smaller-than-expected loss of U.S. jobs in May slammed the U.S. Treasury debt market on Friday, kindling fears the Federal Reserve might raise interest rate sooner than previously thought.

Renewed selling to hedge against the recent spike in mortgage rates resulted in the biggest single-day jump in the two-year note yield since September, when the global credit crisis erupted.

This abrupt shift in rate outlook also caused the largest weekly jump in benchmark 10-year yields in nearly six years.

Long-dated yields have risen swiftly since March on anxiety over inflation stemming from the $2 trillion in new government borrowing this fiscal year. There have also been concerns that a burgeoning federal debt load will choke off nascent signs of economic stabilization and end up damaging the dollar and United States' credit rating in the long run.

"We are going to have to start raising rates or you'll have hyper-inflation," said Howard Simons, market strategist at Bianco Research in Chicago.

U.S. short-term interest rate futures, which track market expectations on Fed rate policy, made their first meaningful move in months -- advancing the possible timing of the first Fed rate hike to late 2009 from early 2010. For more see[ID:nN05276580].

The spike in yields is seen as counteracting other Fed measures like its near-zero interest rate policy aimed at ending the worst U.S. recession in decades.

Some analysts were dubious of the health of the jobs market and the overall economy in light of a hefty rise in the jobless rate last month to 9.4 percent, a near 26-year high.

"This will still be a long climb out of the economic cellar. I am not buying this Fed rate hike story," said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.

FED AND SURGING YIELDS

Fed policy-makers, who will meet in two weeks, have acknowledged the jump in yields, but downplayed the likelihood that inflation worries were behind the move.

On Friday, San Francisco Fed President Janet Yellen said at a panel the Treasury sell-off would be "disconcerting" if it were driven by inflation fears. [ID:nN05496187]

Benchmark 10-year note US10YT=RR traded 1-1/32 lower in price, above its session low seen shortly after a government report showed the loss of 345,000 jobs in May, the fewest since September and far less than the 520,000 consensus forecast. [ID:nN05274048]

The 10-year yield, which moves inversely to its price, was 3.84 percent after hitting a six-month high of 3.90 percent. It was at 3.71 percent late on Thursday.

The two-year note US2YT=RR, which is more sensitive to changes in Fed rate expectations, ended down 21/32 for a yield of 1.30 percent from 0.96 percent late on Thursday.

The Treasury yield curve, or the spread between the yield on 2-year notes and 10-year notes, expanded to as much as 281 basis points, its widest on record.

But the subsequent rise in two-year note yield shrank the gap or flattened the curve to 253 basis points in late trade.

The Treasuries market potentially faces another rocky week as the government is slated to sell $65 billion in coupon debt including 10-year and 30-year securities, analysts said. (Additional reporting by John Parry and Chris Reese; Editing by James Dalgleish)