Treasury yields rose on Wednesday as the West unveiled more sanctions against Russia over its move into eastern Ukraine, but bond investors remained mainly concerned about inflation and a potential Federal Reserve policy mistake.

Ukraine declared a state of emergency and told its citizens in Russia to flee, while the United States and allies kept tougher measures in reserve in case Moscow unleashes a full-scale assault.

Bond Market Relatively Calm

U.S. and European stocks fell, but the Treasury market was relatively calm. The yield on benchmark 10-year U.S. Treasury notes rose 2.1 basis points to 1.969%.

A closely watched part of the yield curve measuring the gap between yields on two- and 10-year Treasury notes, seen as an economic indicator, was at 37.7 basis points after earlier flattening to almost two-year lows.

"The market is pricing a policy mistake," said Nancy Davis, managing partner and chief investment officer at Quadratic Capital Management LLC. "The market also believes the Fed's hiking (of interest rates) is going to put the economy in recession."

Even if investors believe inflation is transitory, as the Fed had indicated until recently, Davis said they would not buy 10-year Treasuries yielding less than 2% as it is not rational.

"The rates market has priced in a transitory if not deflationary outcome," Davis said.

Treasury yields rebounded from three-week lows overnight on Wednesday as investors cut exposure to safe-haven government debt and awaited Russian President Vladimir Putin's next move after he sent troops into separatist regions of Ukraine.

Spreads have collapsed by nearly two-thirds from more than 90 basis points in early January as expectations of higher U.S. rates lifted yields at the short end of the bond curve.

Ukraine & Its Impact on the Fed

The escalating Ukraine crisis has injected fresh uncertainty into the debate on whether the Fed will increase rates by 50 basis points next month, which some market participants saw as a near-uncertainty until early last week.

Money markets are pricing in a 36.5% probability of a 50-basis-point rate hike in March, the same as Tuesday, but down from around 60% recently.

The Fed cannot afford to delay a rate hike as some suggest because of "uncertainty" in the market as the economy is strong and wages are up, said Kenneth Broux, an FX strategist at Societe Generale in London.

It is "not the moment to worry about demand destruction. They must regain credibility on inflation, and that's a recipe for further flattening," Broux said.

The rise in inflation is increasingly broad-based as opposed to extreme moves in a few supply-constrained categories as it was much of last year, Goldman Sachs said in a note.

The core price index for personal consumption expenditures, a measure for goods and services without volatile food and energy prices, is forecast in a Reuters poll at an annual 5.1% for January.

The Treasury sold $53 billion in five-year notes to yield 1.88%. A strong auction often has been seen in this rising-rates environment followed by poor performance later, Tom Simons, money market economist at Jefferies LLC, said in a note.

$1.738T Record Reverse Repo Bids

The Federal Reserve accepted a record $1.738 trillion in overnight reverse repo bids, the New York Fed said.

The two-year U.S. Treasury yield, which typically moves in step with interest rate expectations, was up 0.3 basis points at 1.590%.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.976%.

The 10-year TIPS breakeven rate was last at 2.546%, indicating the market sees inflation averaging about 2.55% a year for the next decade.

The U.S. dollar five years forward inflation-linked swap , seen by some as a better gauge of inflation expectations due to possible distortions caused by the Fed's quantitative easing, was last at 2.357%.