TREASURIES-Yields drop as US data, tariffs fuel stagflation worries

By Davide Barbuscia

NEW YORK, March 28 (Reuters) - U.S. Treasury yields tumbled on Friday as investors assessed the likely negative hit on growth from President Donald Trump's tariffs alongside inflation persistently stuck above the Federal Reserve's goals.

A Commerce Department report showed that the Personal Consumption Expenditures Price Index increased as expected by economists surveyed by Reuters. However, excluding volatile components like food and energy, the index rose 2.8% year-over-year in February, exceeding the forecast 2.7% gain, while consumer spending rebounded after declining in January.

Meanwhile, a wave of reciprocal tariffs Trump plans to unveil next week continued to loom large over markets, with investors nervous over the extent of the import duties in the final policy.

"The bond market and markets in general are consternating about the softer growth versus higher and persistent inflation," said George Cipolloni, portfolio manager at Penn Mutual Asset Management. "The PCE number today was more of a stagflation print ... That's not the best environment to be in."

Stagflation is a mix of sluggish growth and relentless inflation that haunted the U.S. in the 1970s. With the threat of more tariffs, "it feels like it (stagflation) is going to be more and more likely of an outcome, in terms of a slower growth and high-cost type of environment," said Cipolloni.

The Personal Consumption Expenditures (PCE) price index increased 0.3% in February, in line with forecasts, after advancing by an unrevised 0.3% in January. In the 12 months through February, prices increased 2.5%, matching January's rise.

Treasury yields, which move inversely to prices and were already lower on the day, edged higher immediately after the PCE data but then pared back those increases and kept declining.

The bond rally gained more momentum after the release of a University of Michigan survey showing consumer sentiment dropped in March to a more than two-year low, while long-run inflation expectations topped 4%, double the Fed's target.

"In theory tariffs should be a one-time price increase, but ... consumers are not making that distinction and are assuming these higher prices are going to continue into the future for quite some time," said Ayako Yoshioka, portfolio consulting director at Wealth Enhancement Group.

"For the bond market the focus really is on the growth scare we're getting and whether this is going to turn into something else," she added.

Traders in interest rate futures anticipated a more accommodative Federal Reserve, betting on a total of about 73 basis points in interest rate cuts this year, around 10 basis points more than before the PCE release, according to LSEG data.

San Francisco Fed President Mary Daly said on Friday she still saw two interest-rate cuts this year as a "reasonable" projection, though the central bank could wait to cut rates to assess how businesses adjust to tariff costs.

"This elevated inflation places the Fed in a challenging position regarding future rate policy," Matt Stephani, president of Cavanal Hill Investment Management, said in emailed comments.

"While the economy appears solid, business executives are adopting a cautious stance on new investments, largely due to the Trump administration's aggressive and unpredictable tariff policy," he said.

Benchmark 10-year yields US10YT=RR were last at 4.255%, over 11 basis points lower on the day - the biggest one-day drop since February 13. Two-year yields US2YT=RR, which reflect expectations of shorter-term changes in monetary policy, shed about nine basis points, their biggest daily drop since March 10, and were last at 3.908%, the lowest in over two weeks.

The closely watched part of the yield curve that plots the premium of 10-year yields over two-year yields was at about 34 basis points, slightly flatter than on Thursday.