NEW YORK, June 11 (Reuters) - A drop in two-year Treasury prices flattened the yield curve on Tuesday after a Labor Department report showed producer prices increased in May for the second consecutive month, pointing to a steady pick-up in underlying inflation pressures.
Producer prices excluding food, energy and trade services rose 0.4% last month, matching April’s gain, the government said. The so-called core PPI increased 2.3% in the 12 months through May after rising 2.2% in April.
The report appears supportive of the Federal Reserve’s view that recent weak inflation readings are transitory. 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.
A rate cut, however, is not expected next Wednesday.
An increase in inflation could temper those expectations, because the Fed uses rate hikes to contain gains in inflation. The two-year yield, which reflects market expectations of rate hikes, rose 3.4 basis points to 1.934% in morning trade. That narrowed the spread between two- and 10-year yields, the most common measure of the yield curve, to 22.1 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 have been roughly stable since Monday, last around 66.7%, 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.
The Treasury Department’s auction of $78 billion of government debt this week, beginning with the sale of $38 billion in three-year government notes on Tuesday, will also be in focus. Increased supply tends to lower prices and lift yields, broadly the trend in Tuesday morning trade.
“The focus is going to be on supply so there might be a little bit of a concession getting built into the market ahead of the auctions,” said Rajappa.
“We’ve seen a tremendous rally in bonds, so given today’s concession I think the three-year auction should go OK.”
Reporting by Kate Duguid; Editing by Dan Grebler