* Two-year yield reaches 5-year high
* Fed raises key rate 25 basis points (New throughout, updates market action and adds new quotes)
By Tariro Mzezewa
NEW YORK, Dec 16 (Reuters) - Yields on shorter-dated U.S. Treasuries rose sharply on Wednesday after the Federal Reserve increased its benchmark rate by 0.25 percentage point, its first hike in nearly a decade, signaling confidence in the strength of the domestic economy.
The Fed made clear that the move was a tentative beginning to a “gradual” tightening cycle, and that in deciding its next increase it would put a premium on monitoring inflation, which remains mired below target.
“Low inflation is a persistent problem. Central banks around the world have been thus far unsuccessful in their attempts to generate inflation, and the Fed won’t be able to hike as swiftly as they’d like if inflation stays low,” said Pravit Chintawongvanich, head derivatives strategist for broker-dealer Macro Risk Advisors in New York.
While the rate move had been almost fully priced in, investors were paying close attention to the words used by the central bank to communicate the pace of future hikes.
“Yellen did a good job of communicating that they won’t just make fast changes without considering everything that’s going on. The Fed has regained credibility in terms of communicating what they will do going forward,” said John Bredemus, vice president of Allianz Investment Management-U.S., based in Minneapolis.
Traders had been increasing their curve-flattening positions in anticipation of a 2015 rate hike, which involved reducing holdings of short-dated Treasuries and increasing stakes in longer ones.
“In regard to the actual announcement, it’s more a symbolic movement than anything else, which is why we’re seeing a muted curve flattening move,” said Ninh Chung, head of investment strategy at Silicon Valley Bank in San Francisco.
Yields on 5-year Treasuries were at their highest for the session following the announcement by the Fed and the yield differential between 5-year notes and 30-year bonds shrank to 125 basis points. The yield on the two-year note reached a 5-year high of 1.021.
U.S. benchmark 10-year Treasury notes were last down 9/32 in price to yield 2.297 percent, up from 2.266 percent late on Tuesday.
The U.S. 30-year bond was last down 10/32 in price to yield 3.00 percent, up from 2.991 percent late Tuesday.
“It’s all about next year and what will happen with inflation and the pace of hikes,” said Eric Stein, co-director of global income at Eaton Vance in Boston.
Editing by Meredith Mazzilli and Tom Brown