* U.S. Treasuries set for 3rd worst year in 4 decades -Barclays
* U.S. 10-year yield breaks above 3 percent on light volume
* Two-to-10-year yield gap grows to widest since 2011
NEW YORK, Dec 27 (Reuters) - U.S. benchmark Treasuries yields rose above 3 percent to their highest level in more than two years on Friday, nearly assuring 2013 becomes one of the bond market's worst years in decades. Traders further pared their bond holdings in anticipation of a further increase in yields in 2014, when the Federal Reserve will buy fewer bonds, after Fed policy-makers expressed some confidence the economy can grow with less monetary stimulus. The key challenge facing investors in coming months is preparing for how quickly bond yields might rise, analysts say. "The 10-year yield has been normalizing as the data have been coming in stronger," said Quincy Krosby, market strategist with Prudential Financial in Newark, New Jersey, which has $1 trillion in assets under management. The 10-year Treasury yield is a benchmark for mortgage rates and other long-term loan costs, as well as investment returns. A steady, moderate increase in yields to, say, 3.5 percent should not harm the housing recovery or the Wall Street equities that set record highs in recent days, analysts said. Big swings in yields toward 4 percent or 2 percent, however, could spook investors, causing them to pull money from stocks and other risky assets. "As long as it happens slowly, it's not threatening for other markets. What markets don't want is a sharp move in either direction," Krosby said. The rise in 10-year Treasuries yield has been steep, jumping 1.4 percentage points since May, when Fed Chairman Ben Bernanke told a congressional panel the central bank might consider scaling back its third round of quantitative easing, which has blown up its balance sheet by over $1 trillion. Last week, the U.S. central bank said it will reduce its monthly purchases of Treasuries and mortgage-backed securities improving economy. At the same time, the Fed signaled its commitment to hold short-term interest rates near zero because unemployment has remained higher than policy-makers like and inflation has been stuck below their 2 percent target. "The economic data have been better-than-expected, while at the same time the Fed is promising to be easier for longer. Then there's more chance of inflation later, which is driving the 10-year yield higher," said Lou Brien, market strategist at DRW Trading in Chicago. Domestic inflation has remained low because wages have not been rising much. While there has been a pickup in monthly job creation, much of the accelerated hiring has been in low-paying services sectors, analysts said. Barring a massive rally before year-end, the Treasuries market should book one of its worst years on record. The Treasuries market has fallen 2.75 percent through Thursday, on track for its third steepest annual loss going back to 1973, according to an index compiled by Barclays. Five years earlier, the Treasuries market lost 3.57 percent. In 1994, it fell 3.38 percent, the Barclays data showed. However, analysts downplayed the 10-year yield's breach of the 3 percent threshold for the second time this year due to the light post-Christmas trading volume. "People are not going to set up new positions right now based on this number," DRW's Brien said. There was no major economic release on Friday and the Fed will not resume buying Treasuries until later next week. On the open market, the 10-year Treasury note last traded up 2/32 in price as some bargain-driven buying emerged. It fell as much as 7/32 in price earlier. The 10-year yield was last 2.987 percent after touching 3.02 percent, the highest intraday level since July 2011, according to Reuters data. The yield spread between two-year and 10-year Treasuries grew to 2.61 percent, its widest since July 2011, up from 2.58 percent on Thursday and 2.51 percent a week earlier. On Wall Street, the three major equity indexes retreated from opening higher, but were still expected to post gains of more than 1 percent in a holiday-shortened week.