TREASURIES-US yields drop as trade, regional bank worries dent risk appetite

By Chuck Mikolajczak

NEW YORK, Oct 16 (Reuters) - U.S. 10-year Treasury yields dropped on Thursday, with the yield on the two-year note hitting its lowest level in over three years, as concerns over trade tensions between the U.S. and China along with credit market worries curbed the appetite for riskier assets.

Yields have moved sharply lower since Friday, when U.S. President Donald Trump threatened to raise tariffs on Chinese goods to triple digits, followed this week by both countries charging additional port fees on ocean shipping firms and criticism by U.S. officials of China's expanded rare earth export controls.

After holding near the unchanged mark in early trading, yields tumbled as U.S. stocks sold off, weighed down by declines in regional banks after Zions Bancorporation ZION.O said it would take a charge-off on two commercial and industrial loans, increasing concerns about the credit market on the heels of bankruptcies by auto parts maker First Brands and subprime lender Tricolor.

"The markets are starting to react to the potential that a more intense trade war could actually hurt not only the world economy, but certainly our economy," said Ron Albahary, chief investment officer at LNW in Philadelphia. He said the credit concerns increased anxiety.

"At this point, what we might be seeing is just a flight to quality, a traditional flight to quality, which is causing Treasuries to rally a bit here."

The yield on the benchmark U.S. 10-year Treasury note US10YT=TWEB declined 6.9 basis points to 3.976% after falling to 3.971%, its lowest level since April 7.

Federal Reserve Governor Christopher Waller said he would like a 25 basis point interest rate cut at the central bank's October meeting due to the mixed labor market readings but sees a slower path of cuts should the job market speed up or GDP holds up while fellow Governor Stephen Miran again made the case for an even more aggressive path of cuts.

Markets are fully pricing in a cut of at least 25 basis points at the Fed meeting later this month, according to CME's FedWatch Tool, with a 3.2% chance for an outsized 50 basis point reduction.

The two-year US2YT=TWEB U.S. Treasury yield, which typically moves in step with interest rate expectations for the Fed, tumbled 8 basis points to 3.426% after dropping to 3.412%, its lowest since September 2022.

Investors have also been grappling with a lack of economic data due to the ongoing government shutdown.

Despite the government shutdown, some economic data was still being released. The Philadelphia Federal Reserve Bank said its business activity index dropped to -12.8 this month from 23.2 in September and below the 8.5 estimate of economists polled by Reuters. A reading below zero indicates contraction.

In addition, the National Association of Home Builders/Wells Fargo Housing Market index showed homebuilder sentiment jumped to a six-month high in October amid hopes that declining mortgage rates would stimulate demand for housing.

The yield on the 30-year bond US30YT=TWEB fell 5.5 basis points to 4.583%.

A closely watched part of the U.S. Treasury yield curve measuring the gap between yields on two- and 10-year Treasury notes US2US10=TWEB, seen as an indicator of economic expectations, was at a positive 54.7 basis points.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) US5YTIP=TWEB was last at 2.317% after closing at 2.351% on Wednesday, its lowest since June 30.

The 10-year TIPS breakeven rate US10YTIP=TWEB was last at 2.274%, indicating the market sees inflation averaging about 2.3% a year for the next decade.