RPT-TREASURIES-US yields fall on weak data, Fed comment on balance sheet reset

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By Herbert Lash

NEW YORK, March 1 (Reuters) - Treasuries rallied on Friday after U.S. manufacturing slumped further in February amid signs of a rebound, while the two-year yield fell to a two-week low after a Federal Reserve official suggested the need for more shorter-dated Treasuries.

The Institute for Supply Management (ISM) said its purchasing managers index for manufacturing fell to 47.8 from 49.1 in January. It was the 16th straight month that the PMI remained below 50, which indicates contraction.

The ISM survey showed customer inventories declining for a third straight month, considered positive for future new orders and production growth.

The University of Michigan's surveys of consumers also was weak, with all three measures for sentiment, current conditions and consumer expectations declining more than expected.

The two-year Treasury yield, which reflects interest rate expectations, fell 10.6 basis points to 4.540%, it's biggest single-day decline since Jan. 31. The yield on the benchmark 10-year note slid 6.6 basis points to 4.186%. Yields move inversely to prices.

For the week, the two-year's yield fell 16 basis points and the 10-year's yield 8.4 basis points.

"The data were quite weak, weaker than expected, especially the ISM and the consumer sentiment numbers," said Kim Rupert, managing director of global fixed income at Action Economics in San Francisco.

"The market has been overly taking out Fed rate cut expectations, settling into something closer to what the Fed was expecting," she said. "So it's just bouncing back and forth between rate cut expectations. Today's data gave some support to a rate cut by June."

While manufacturing accounts for about 11% of the economy, recent labor market and consumer spending has suggested economic growth remains strong despite the Fed's most aggressive hiking of interest rates in four decades.

With the 10-year's yield tumbling from 16-year highs just over 5% in October, the economy has expanded and will make the inflation fight harder, said Mauricio Aguedelo, head of fixed-income investments at Homestead Funds in Arlington, Virginia.

"You are seeing growth re-accelerating because with stability in lower rates, corporations are able to borrow," he said. "It will continue to make the Fed’s job difficult if they want to cut and how aggressive they want to be in cutting rates."

Policymakers have pushed back this year on market expectations for how soon and how deep the Fed will cut rates.

The market misinterpreted what Fed Chair Jerome Powell was trying to communicate in December when investors saw a dovish message, said Roosevelt Bowman, senior investment strategist at Bernstein Private Wealth Management in New York.

"They were talking about conditions where they could cut rates before they reached the 2% target and a lot of investors took that to mean, 'Oh rate cuts are coming, they're going to be sizable, they're going to be immediate.'"

Fed Governor Chris Waller sparked a rally in shorter-duration Treasuries on Friday when he addressed a conference at the University of Chicago's Booth School of Business.

Waller said he would like the U.S. central bank to address a reset of the balance sheet towards shorter-term Treasury bills that would better match the short-term policy rate that the Fed controls as its key monetary policy tool.

Such a shift would likely increase the purchase of shorter-term Treasuries.

"Markets are trying to digest data and Fed speak today," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities in New York.

"Markets are a little bit confused as to what the data is actually telling us. Investors are not fully comfortable pricing the odds of Fed rate cuts where they are now and they're looking for more information."

The yield on the 30-year Treasury bond fell 4.4 basis points to 4.331%.

The yield curve measuring the gap between two- and 10-year Treasury yields, seen as a recession harbinger when its inverted - or showing shorter-duration securities are higher than longer ones - at 35.6 basis points.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.446%.

The 10-year TIPS breakeven rate was last at 2.322%, indicating the market sees inflation averaging about 2.3% a year for the next decade. (Reporting by Herbert Lash; Editing by Kirsten Donovan and Nick Zieminski)