TREASURIES-Two-year yields lowest since May as Fed policy in focus

By Karen Brettell

Aug 27 (Reuters) - Interest rate sensitive two-year yields fell to an almost four-month low on Wednesday and the yield curve steepened as traders evaluated the likelihood that U.S. President Donald Trump will be able to make more dovish appointments to the Federal Reserve.

Fed Governor Lisa Cook's lawsuit against Trump's effort to fire her could be filed as soon as Wednesday.

Traders expect Fed policy could be more dovish if Trump is able to make more appointments to the U.S. central bank. Trump has repeatedly criticized Fed Chair Jerome Powell for being too slow to cut interest rates.

At the same time, weak jobs data for July and more dovish comments from Powell on Friday have led traders to increase bets that the Fed will cut rates at its September 16-17 meeting.

The outlook for rates, however, is still likely to depend on the strength of the labor market going forward and inflation trends, which remain unclear.

“There is more confidence that we're going to get some rate cuts here in the near term, and there's a difference of opinion on how far that extends beyond the next couple of months,” said Thomas Simons, chief U.S. economist at Jefferies in New York.

“It's still unclear to me that whatever is going on right now and whatever power Trump can wield to install various folks in the Fed is enough to sway the overall opinion,” Simons added.

New York Fed President John Williams said on Wednesday it is likely interest rates can fall at some point but policymakers will need to see what upcoming data indicate about the economy to decide if it's appropriate to make a cut at next month’s meeting.

Fed funds futures traders are pricing in 88% odds of a cut in September, according to the CME Group's FedWatch Tool.

The two-year note yield US2YT=RR was last at 3.654%, down around two basis points on the day. The benchmark 10-year note yield US10YT=RR was at 4.289%, up from 4.256%.

The yield curve between two-year and 10-year notes US2US10=TWEB was last at 63.3 basis points, the steepest since April 22.

A politically influenced Fed that keeps interest rates lower than they otherwise might could increase concerns over rising inflation and reduce foreign demand for the debt on credibility fears. Those factors would weigh on longer-dated debt and steepen the yield curve.

The Treasury Department will sell $70 billion in five-year notes on Wednesday, the second sale of $183 billion in short- and intermediate-dated supply this week.

The U.S. government saw strong demand for a $69 billion sale of two-year notes on Tuesday and will also sell $44 billion in seven-year notes on Thursday.