I have a list of words:
bau ceu diu fou gau
I want to turn that list into:
byau cyeu dyiu fyou gyau
I uns
If you don't want to escape the capturing groups with backslashes (this is what you've missed), prepend \v to turn Vim's regular expression engine into very magic mode:
\v
:%s/\v(\w)(\w\w)/\1y\2/g