TREASURIES-Yields slip after producer price data, long bond in tight range pre-auction

By Alden Bentley

NEW YORK, Sept 10 (Reuters) - Treasury yields fell on Wednesday after a surprising drop in August producer prices strengthened the argument for an interest rate cut next week, while a solid 10-year note auction lowered the benchmark yield a bit more in the afternoon.

The Labor Department said on Wednesday that its Producer Price Index for final demand dipped 0.1% after a downwardly revised 0.7% jump in July, thanks to a drop in the costs of services. Economists polled by Reuters had forecast the PPI would rise 0.3% after a previously reported 0.9% July surge.

"It's not that a rate cut was in doubt after Powell, but the data just do suggest that the Fed can cut rates, and now it's a question of size," said Kim Rupert, managing director of fixed income at Action Economics in San Francisco, referring to Federal Reserve Chair Jerome Powell's comments at the August Jackson Hole, Wyoming, economics symposium suggesting an easing could come soon.

Futures markets are all but certain the Federal Open Market Committee will ease, for the first time since December, by a quarter point after next week's meeting. Traders see a small 7% chance of a larger 50-basis-point cut, talk of which picked up after Friday's shockingly downbeat U.S. payrolls report showing only 22,000 positions were created in August.

The cool PPI report could help solidify a Fed decision to loosen policy again, but more important will be Thursday's Consumer Price Index, ahead of which markets have been reluctant to trade too much.

Demand was solid for the Treasury's sale of $39 billion of 10-year notes. The bid-to-cover ratio was the highest since April.

Lou Brien, strategist at DRW Trading in Chicago, said in a note that indirect bidders, which include foreign investors and central banks, took the second-highest percentage on record, while direct bidders who submit bids for their own accounts - namely big funds and banks - got crowded out.

An even more telling gauge of demand for U.S. debt, at least in the long end, comes with the Treasury's $22 billion sale of 30-year bonds on Thursday.

The 30-year yield has come down more than 30 basis points since it briefly topped 5% for the first time since mid-July a week ago.

The selloff that lifted the long-bond yield to 5% immediately drew buyers. While there was no concession on Wednesday lifting yields before the auction, the 10-year result and a stellar U.S. three-year note auction on Tuesday were a good setup.

The yield on the benchmark U.S. 10-year Treasury note US10YT=TWEB fell 3.6 basis points to 4.038%. The yield on the 30-year bond US30YT=TWEB initially rose after the inflation data but ended off 3.2 basis points at 4.685%.

A closely watched part of the U.S. Treasury yield curve that measures the gap between yields on two- and 10-year Treasury notes US2US10=TWEB and is seen as an indicator of economic expectations, flattened to +49.6 basis points.

The two-year US2YT=TWEB U.S. Treasury yield, which typically moves in step with interest rate expectations for the Fed, slipped 0.4 basis points to 3.538%.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities US5YTIP=TWEB was last at 2.442% after closing at 2.455% on September 9.

The 10-year TIPS breakeven rate US10YTIP=TWEB was last at 2.357%, indicating the market sees inflation averaging below 2.4% a year, not far from the Fed's 2% target, for the next decade.