TREASURIES-Two-year yields fall after consumer price inflation data

By Karen Brettell

Aug 12 (Reuters) - Interest rate sensitive two-year Treasury yields fell on Tuesday as July U.S. consumer price inflation came roughly in line with estimates, with limited tariff pressure, boosting bets that the Federal Reserve will cut interest rates in September.

The consumer price index rose 0.2% last month after gaining 0.3% in June, for an annual gain of 2.7%, unchanged from the prior month.

Excluding the volatile food and energy components, the CPI rose 0.3%, the biggest gain since January, after climbing 0.2% in June. The so-called core CPI increased 3.1% year-on-year in July after advancing 2.9% in June.

"What the data today tells us is inflation isn't making much progress towards the Fed's 2% target. But at the same time, it's not taking off, as some have feared, around tariff effects," said Matt Bush, U.S. economist at Guggenheim Investments.

Investors boosted bets that the Fed will cut rates sooner and potentially more than previously expected after jobs data for July showed employers added fewer jobs than expected, while job gains for previous months were also revised sharply lower.

Fed policymakers including Chair Jerome Powell have been reticent to cut rates on concerns that inflation will rise this summer due to the Trump administration's tariff policies.

"Given the weak July jobs numbers and the fact that inflation isn't quite as bad as feared, it does make a September rate cut likely," said Bush.

Fed funds futures traders are pricing in 94% odds the Fed will cut rates at the U.S. central bank's September 16-17 meeting, up from 86% on Monday, according to the CME Group's FedWatch Tool.

"The July CPI was roughly in line with expectations and did not include very much tariff pass-through to consumer prices and is certainly good enough to lock in the odds of a September rate cut," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia.

"At this point in the cycle, the jobs data matter more than the inflation data."

The 2-year note US2YT=RR yield was last down 2.3 basis points on the day at 3.731%. The benchmark U.S. 10-year note yield US10YT=RR rose 2.2 basis points to 4.295%.

The yield curve between two- and 10-year notes US2US10=TWEB steepened around five basis points to 56.5 basis points after reaching 57.3 basis points, the steepest level since July 16.

U.S. President Donald Trump, who has repeatedly criticized Powell for being too slow to cut rates, on Tuesday reiterated his call for the Fed to lower benchmark rates, and cited "a major lawsuit" against Powell over renovations of the central bank's buildings.

Kansas City Fed President Jeffrey Schmid said the U.S. central bank should not take tariffs' muted effect on inflation so far as an opportunity to cut rates, but rather as a sign that monetary policy is "appropriately calibrated."

Richmond Fed President Tom Barkin said aggressive shopping by consumers may mute the impact of tariffs on inflation but could also lead to a cycle of falling demand and rising unemployment.

The U.S. government's budget deficit grew nearly 20% in July to $291 billion despite a $21 billion jump in customs duty collections from tariffs, with outlays growing faster than receipts, the Treasury Department said on Tuesday.