TREASURIES-U.S. short-term yields hit multi-year highs, yield curve flattens on Fed bets

on Fed bets@

* U.S. two-year yields hit highest since 2008

* Three-year yields hit highest since 2009

* Five to 30-year yield curve flattest since 2007

(Updates to U.S. afternoon trading, adds quote) NEW YORK, Dec 5 (Reuters) - Short-dated U.S. Treasury yields rose to their highest in more than eight years on Tuesday as investors increasingly expected the U.S. Congress to pass tax reform legislation and the Federal Reserve to raise interest rates several times next year. The yield on the two-year note touched its highest since October 2008 and the three-year note yield hit its highest since June 2009. The yield curve flattened, with the difference between the yields on five- and 30-year debt hitting its lowest in a decade as yields on longer-dated Treasuries fell. Fed funds futures prices show that investors see a rate increase at the U.S. central bank's Dec. 12-13 meeting as a certainty and odds of bringing the U.S. overnight interest rate to a range of 1.50-1.75 percent, a 50-basis-point hike, have risen to nearly 10 percent. Futures prices show a zero percent chance of rates remaining at their current level of 1.00-1.25 percent.

The yield on two-year Treasury note , the most

sensitive to Fed policy expectations, rose to 1.835 percent. The

three-year note yield touched 1.95 percent.

The spread between yields on the five-year Treasury note and 30-year bond dropped to 57.3 basis points, the narrowest since October 2007. The 30-year bond rose 26/32 in price to yield 2.73 percent, down around four basis points from its late Monday levels. Data released Tuesday showed the U.S. trade deficit increased to a nine-month high in October because of rising oil prices and the widening of America's long-standing deficits with China and Mexico. Additionally, the Institute for Supply Management (ISM) said its non-manufacturing index fell in November, missing economists' expectations. Investors are pricing in multiple rate increases from the Fed in response to strong U.S. employment data and a recent pickup in inflation but see limited upside for long-term inflation, even with passage of the proposed tax bill. "You get some exhaustion from the tax reform, knowing that theres still work to be done. Theres still other problems and then you combine that with a little bit of underwhelming economic information and that leads to a little bit of retracement," said Justin Hoogendoorn, head of fixed income strategy at Piper Jaffray & Co. Evercore ISI strategist Stan Shipley said investors also are undervaluing the possibility of a U.S. government shutdown if lawmakers cannot reach a budget accord this week. Government funding is set to expire Friday. "Talking to international clients they are completely oblivious to this," he said. "Issues on tax reform and Trump have captured their attention and theyre not thinking about what a shutdown could do."

(Reporting by Dion Rabouin; Editing by Steve Orlofsky)