TREASURIES-Yields fall as US tensions with Iran escalate

By Karen Brettell

June 17 (Reuters) - U.S. Treasury yields fell on Tuesday as concerns about escalating tensions between the United States and Iran boosted demand for safe-haven debt, a day before the Federal Reserve is due to update its economic and interest rate projections.

President Donald Trump said on Tuesday that U.S. patience was wearing thin but it had no immediate intention to "take out" Iran's leader, while indicating he could dispatch diplomatic envoys as the Israel-Iran air war raged for a fifth day.

"We're seeing yields fall a little bit further... and I think that's largely on anxiety over the Middle East," said Kim Rupert, managing director at Action Economics in San Francisco.

Benchmark 10-year yields US10YT=RR were last down 5.9 basis points at 4.395%. The yield on the interest rate-sensitive 2-year note US2YT=RR fell 2.4 basis points to 3.946%.

The yield curve between two-year and 10-year notes US2US10=TWEB flattened by around 3 basis points to 45 basis points.

The conflict with Iran may add to uncertainty over the outlook for the U.S. economy if it leads to persistently higher oil prices.

"The Middle East situation adds another layer of complexity to an already difficult situation. The markets are a little bit split between whether Powell's tone will be more dovish or hawkish" on Wednesday, said Rupert.

Fed Chair Jerome Powell is to hold a press conference on Wednesday following the Fed's release of its policy decision at the close of its two-day meeting.

The Fed is expected to hold rates steady as Fed officials wait to see the impact on the economy of the Trump administration’s tariff policies. Policymakers have expressed concerns that the trade levies will slow growth and increase inflation.

"The Fed and Powell have talked a lot about pressure on both sides of the dual mandate, where the risks to a sharper slowdown in the labor market have grown but at the same time the risks to higher inflation have also grown,” said Mike Medeiros, macro strategist at Wellington Management in Boston.

With inflation already elevated and the impact of tariffs still to come, the Fed may be more likely to maintain projections for 50 basis points in cuts for this year, or reduce them to one 25 basis point cut, than it would be to increase its forecast to cuts totaling 75 basis points, Medeiros said.

Fed funds futures traders are pricing in 45 basis points of cuts by year-end, indicating they see two 25 basis point reductions as most likely.

The Treasury Department saw strong demand for a $23 billion sale of five-year Treasury Inflation-Protected Securities on Tuesday, indicating that some investors may be anticipating higher inflation.

The debt sold at a high yield of 1.650%, almost two basis points below where it had traded at the bidding deadline. Demand was above average at 2.53 times the amount of debt on offer.

Market reaction was subdued to data showing that U.S. retail sales dropped more than expected in May, declining 0.9%. U.S. import prices were unchanged in May amid lower costs for energy products.

Traders are also focused on a tax and spending bill in the U.S. Congress, which would likely provide some short-term economic stimulus but would increase the U.S. debt load over the coming decade.

The fiscal impact of the bill could offset some of the growth hit from tariffs, though it could also result in higher-for-longer inflation, said Medeiros.

"If you're going to constrain the supply side of the economy through tariffs and immigration restrictions and then boost short-term demand through fiscal policy, then that would increase the probability that inflation is actually sustained a bit higher for a bit longer, and I don't think that's necessarily in the price right now," Medeiros said.

U.S. Senate Republicans on Monday unveiled proposed changes to the sweeping bill that would make some business-related tax breaks permanent while making more limited the deduction for state and local income taxes, angering some colleagues in the House of Representatives.

The bond market will be closed on Thursday for the federal Juneteenth holiday.