TREASURIES-Yields give back earlier plunge, focus on Fed rate path

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(Adds quote, 10-year auction results, comments from Fed officials, updates prices) By Karen Brettell NEW YORK, Aug 10 (Reuters) - U.S. Treasury yields gave back most of an earlier drop on Wednesday as investors evaluated how high the Federal Reserve is likely to raise rates when it meets in September, after data showed inflation gains stalled in July. U.S. consumer prices were unchanged in the month due to a sharp drop in gasoline prices, delivering the first notable sign of relief for Americans who have watched inflation climb over the past two years. The Consumer Price Index (CPI) rose by an annual rate of 8.5% in July, while the core CPI, which excludes volatile food and energy costs, gained 5.9%. The drop in Treasury yields immediately after the data indicates traders were expecting a rise in inflation. "The downside miss is certainly not something the markets were positioned for, I think the market was really one way positioned for a higher inflation print and higher Fed pricing,” said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York. The inflation report came after investors ramped up bets that the Fed would be more hawkish following data on Friday showing that U.S. job growth unexpectedly accelerated in July. "The combination of (nonfarm payrolls) and CPI for July leave the 75 bp vs. 50 bp Sept hike debate alive and well. Moreover, this means volatility around incoming data will remain elevated," Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets said in a note. Fed funds futures traders are now pricing in a 42% chance that the U.S. central bank will hike rates by 75 basis points when it meets in September, compared to 68% earlier. A 50 basis point increase is seen as a 58% probability. Benchmark 10-year note yields fell as low as 2.67%, before bouncing back to 2.79%. Two-year note yields got as low as 3.08%, before rebounding to 3.22%. The yield curve between two-year and 10-year notes was at minus 43 basis points after earlier reaching minus 56 basis points, the deepest inversion since 2000. Expectations for the Fed could change again, with more inflation and employment data for August due before the Fed's September 20-21 meeting. "We’ve only gotten one out of two CPI prints before then and we’ve got another payroll print as well and a full set of data effectively for August, so I think the jury’s still very much out on September," Goldberg said. Chicago Fed President Charles Evans said on Wednesday that the inflation data was the first "positive" reading on price pressures since the Fed began tightening policy, but added that he believes the Fed has plenty more work to do. Minneapolis Fed President Neel Kashkari also said he still believes the U.S. central bank needs to raise its policy rate to 3.9% by year-end and to 4.4% by the end of 2023 to fight inflation. [Neel Kashkari ] The Treasury saw good demand for a $35 billion sale of new 10-year notes on Wednesday, the second auction of $98 billion in new coupon-bearing supply this week. The notes sold at a high yield of 2.755%, around a basis point below where they had traded before the auction. Demand for the was 2.53 times the amount of debt on offer, the best ratio since February. The Treasury saw solid demand for a $42 billion sale of three-year notes on Tuesday and will auction $21 billion in 30-year bonds on Thursday. August 10 Wednesday 3:01PM New York / 1901 GMT Price Current Net Yield % Change (bps) Three-month bills 2.545 2.5971 -0.036 Six-month bills 2.9675 3.0545 -0.091 Two-year note 99-150/256 3.2183 -0.068 Three-year note 99-238/256 3.1497 -0.066 Five-year note 99-48/256 2.9267 -0.053 Seven-year note 98-128/256 2.8638 -0.035 10-year note 100-184/256 2.7901 -0.007 20-year bond 99-136/256 3.2822 0.038 30-year bond 96-180/256 3.0441 0.039 DOLLAR SWAP SPREADS Last (bps) Net Change (bps) U.S. 2-year dollar swap 27.25 2.00 spread U.S. 3-year dollar swap 9.75 1.75 spread U.S. 5-year dollar swap 3.25 0.75 spread U.S. 10-year dollar swap 4.50 -0.25 spread U.S. 30-year dollar swap -31.00 -1.00 spread (Editing by Emelia Sithole-Matarise, Jane Merriman and Josie Kao)