(Recasts; adds auction news, analyst quote; updates yields)
By Kate Duguid
NEW YORK, June 11 (Reuters) - An uptick in U.S. inflation and strong results from a $38 billion Treasury auction on Tuesday drove short-dated yields higher, flattening the yield curve.
Underlying U.S. producer prices increased for a second straight month in May. The report from the Labor Department will likely support the Federal Reserve’s view that recent weak price readings are probably transitory, and that inflation will gradually move toward the central bank’s 2% target.
Fed policymakers are scheduled to meet on June 18-19 against the backdrop of rising trade tensions, slowing U.S. growth and a sharp step-down in hiring in May that have led financial markets to price in at least two interest rate cuts by the end of 2019.
Those expectations may be tempered because the Fed uses rate hikes to contain gains in inflation. The two-year yield , which reflects market expectations of rate hikes, was last up 2.2 basis points to 1.922%. That narrowed the spread between two- and 10-year yields, the most common measure of the yield curve, to 21.6 basis points from 23.9 on Monday.
Investors will closely watch the consumer price index report on Wednesday for further evidence of inflation. Expectations for a cut in July fell on Tuesday and were last around 65.2% from 66.8% on Monday, according to CME Group’s FedWatch tool.
“Really the key data point for this week is going to be CPI. It is a question of whether inflation is transient - every data point is going to be important to make that determination,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale.
Also pulling the front end of the yield curve lower was strong demand at the Treasury Department’s auction of $38 billion of new three-year notes. Indirect bidders, a proxy for foreign buyers, took 56.6% of the supply, the highest since December 2017. The bid-to-cover ratio - an indication of overall demand, was 2.62 - the highest since September 2018.
“The $38 bln three-year auction was well sponsored and better than feared. Perhaps this is a TINA buy - there is no alternative - given the amount of global debt with negative yields,” wrote Kim Rupert, managing director, global fixed income analysis at Action Economics.
“All of the key bidding statistics were better than average, even as the award rate was the richest in well over a year.”
The three-year yield was last 0.8 basis point higher at 1.882%. At the long end, the 10-year yield was 0.4 basis point higher at 2.145% and the 30-year yield 0.1 basis point lower at 2.620%.
Reporting by Kate Duguid; Editing by Dan Grebler