While the prospect is considered all but impossible, a surprise interest rate increase from the Federal Reserve this week would likely trigger a calamitous sell-off in the short end of the Treasury bond market.

For a Fed that prides itself on clarity of communications, it could also generate a crisis of confidence difficult to undo. In addition, the instantaneous yawning gap that such a hike would open between the yield on two-year notes and official interest rates would have traders panicking to sell, analysts said.

It would be totally unanticipated, said Andrew Brenner, head of global fixed income at Hapoalim Securities in New York. The two-year note would get absolutely hammered, and the 10-year would go down, albeit not as fast.

The Fed kept rates on hold at its August policy meeting after 17 straight increases that had taken the benchmark federal funds rate to 5.25 percent. The central bank is almost universally expected to hold rates again at a policy meeting on Wednesday while mulling the extent of an economic slowdown.

Treasury debt prices have generally risen - and yields fallen - since the Fed paused in August, with some investors mulling the idea that the Fed may even be considering cutting rates in the months ahead.


If the totally unexpected happened, and the Fed did raise rates by a quarter percentage point on Wednesday, it would open a half-point of room between the federal funds rate and two-year yields, which are now near 4.90 percent.

You can only have that sort of gap when the Fed is in an easing mode, Brenner said.

Such a gap between the overnight lending rate between banks, and the two-year yield, while rare, would not be unprecedented. The gap was wider in early 2001 as the Fed was in the middle of trimming rates in a recession and in late 1998 when the Fed was also easing monetary policy.

A sudden plummet in the price of the two-year note would push yields sharply higher, further inverting the Treasury curve - the term used when shorter-term yields are higher than longer-term term yields.

It would pummel bonds, said Beth Malloy, bond market analyst at Briefing.com in Chicago.

In addition to instantaneously creating a difficult technical situation, a surprise rate hike would also destroy any confidence in a Fed that has been trying very hard to be as transparent about monetary policy as possible under the chairmanship of Ben Bernanke.

The market would completely lose confidence in these guys, and that would just pile on the sell side if the guys who are running the show can't be trusted at all, Malloy said.

Hapoalim Securities' Brenner also said any hike in interest rates would destroy Fed credibility.

This Fed under Bernanke has gone out of their way to make sure the market understands where they are coming from, and right now there is no one anticipating any kind of rate rise in September, he said. To do something as totally as unexpected as to raise rates this week would add tremendous amount of volatility to the marketplace.