Two-year yields lowest since May as traders price in rate cuts

• Traders see 84% odds of Fed cut in September
• Treasury sees average demand for $70 billion five-year note auction
• US 5-, 30-year Treasury yield curve steepest since August 2021

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 priced in the likelihood of more Federal Reserve rate cuts with U.S. President Donald Trump aiming to make more dovish appointments to the Federal Reserve.

Fed Governor Lisa Cook will file a lawsuit to prevent Trump from firing her, a lawyer for Cook said on Tuesday, kicking off what could be a protracted legal fight over the White House's effort to shape U.S. monetary policy.

Traders expect Fed policy could be tilted toward more easing 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 is appropriate to make a cut at next month’s meeting.

Fed funds futures traders are pricing in 84% odds of a cut in September. In total, they are pricing in 55 basis points in cuts this year and 141 basis points of cuts by the end of 2026.

The two-year note yield US2YT=RR was last at 3.625%, down around five basis points on the day. The benchmark 10-year note yield US10YT=RR fell to 4.236%, the lowest since August 14.

The yield curve between two-year and 10-year notes US2US10=TWEB was last at 61.3 basis points after reaching 63.5 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 30-year yield US30YT=RR was last at 4.915%, after earlier reaching 4.96%, the highest since August 1. The yield curve between five-year notes and 30-year bonds US5US30=TWEB reached 121.8 basis points, the steepest since August 2021.

The Treasury Department saw average demand for a $70-billion sale of five-year notes on Wednesday, the second sale of $183 billion in short- and intermediate-dated supply this week.

The notes sold at a high yield of 3.724%, less than a basis point above where they traded before the auction. Demand was 2.36 times the amount of debt on offer.

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.