TREASURIES-US yields drop as key inflation gauge cools, spending falls

Adds quote, details on economic data, background on Fed policy throughout

By Gertrude Chavez-Dreyfuss, Tatiana Bautzer

NEW YORK, Feb 28 (Reuters) - U.S. Treasury yields fell to new multi-month lows on Friday as bonds continued to rally after a report closely tracked by the Federal Reserve showed annual inflation subsided and consumer spending slowed last month.

Financial markets viewed the data as likely keeping the U.S. central bank on track to cut interest rates at least twice this year.

U.S. yields, which move inversely to prices, briefly ticked higher after the Commerce Department said its Personal Consumption Expenditures Price Index gained 0.3% last month, matching December's unrevised 0.3% rise.

In the 12 months through January, the PCE increased 2.5% after climbing 2.6% in December. Both readings were in line with the expectations of economists polled by Reuters and indicated movement toward the Fed's 2% target.

But the data also showed a consumer spending slowdown, reinforcing signs that the U.S. economy is cooling. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, dropped 0.2% last month after an upwardly revised 0.8% increase in December. Economists polled by Reuters had forecast consumer spending would gain 0.1%.

"I think the data brought good news. It shows the Federal Reserve is making progress and the tight monetary conditions are working", said Jack Ablin, chief investment officer at Cresset Capital Management in Chicago.

Weak consumer confidence and soft manufacturing, retail sales and home sales data in recent weeks sparked a bond rally that pushed yields lower, with investors moving out of stocks into the safety of Treasury markets amid worries about how Trump administration tariff policies will affect growth and inflation.

The benchmark 10-year yield was last at 4.231%, down 5.6 basis points from late on Thursday. It bottomed earlier on Friday at 4.222%, its lowest level since December 11.

The two-year US2YT=TWEB yield, which typically moves in step with interest rate expectations, touched its lowest levels since October 21, and was last down 7.3 basis points at 4.007%.

Expectations the Fed will cut rates by at least 25 basis points at its June meeting edged up after the data, with markets pricing in a 75% chance of a cut, up from nearly 70% in the prior sessions, according to CME Group's FedWatch Tool.

Rate futures are also pricing in 65 basis points of easing this year, or slightly more than two cuts, compared with 60 basis points of rate reductions late on Thursday.

The Fed paused its policy easing in January after bringing rates down a full percentage point from September to December. The central bank's policy rate is currently in the 4.25%-4.50% range.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) EI5Y=RR> was last at 2.520%, up from 2.518% on Thursday. The 10-year TIPS breakeven rate US10YTIP=TWEB was last at 2.364%, slightly higher from 2.361% on Thursday.