(Recasts lead with supply concerns; adds details on Treasury refunding in paragraphs 3-4, comment in paragraphs 5-6, 8, 12-13; updates prices)
NEW YORK, Jan 26 (Reuters) - Treasury yields rose on Friday on concerns about the growing supply of government debt, with next week's Federal Reserve meeting in focus and expectations that the Fed will have to address efforts to reduce its balance sheet.
Yields had declined earlier as data supported an outlook that the Fed can engineer a soft landing.
The U.S. Treasury Department is likely to announce next week one more round of increases in auction sizes when it details the government's borrowing needs for the coming quarter.
The Treasury faces higher spending needs due in part to higher social security and interest rate costs.
Kim Rupert, managing director of global fixed income at Action Economics in San Francisco, said the sale of some Treasury securities has already set records, and she expects to see the Treasury further increase issuance size.
"We already have a couple of coupons at record levels and I suspect a couple more may hit fresh record highs. And after the sour five-year auction on Wednesday, I think there's going to be an ongoing concern," she said.
Five-year notes were sold at auction on Wednesday at a high yield of 4.055%, or higher than at the bidding deadline as investors demanded a better risk premium to take on more debt.
"Supply is going to be a factor," Rupert said. "Who's going to be buying all this debt?"
The two-year Treasury yield, which reflects interest rate expectations,
rose 4.7 basis points
at
4.361
%, while the yield on the benchmark 10-year notes
rose 2.7 basis points
to
4.159
%.
The difference in yields on two- and 10-year notes was at
-20.7
basis points. The curve has been inverted since July 2022, with the shorter-dated security's yield higher than the longer-dated one in what has proven in the past to be a recession harbinger.
Policymakers meet next week when they're expected to keep the target rate at a range of 5.25%-5.50%, but Fed Chair Jerome Powell will likely need to address the U.S. central bank's ongoing reduction of its balance sheet.
"Powell will need to start laying out his plan soon on how he sees the continuing balance sheet runoff evolving," said Dec Mullarkey, a managing director at SLC Management in Boston. "Reducing the balance sheet too much or too quickly can shock market functioning and lead to spikes in short-term lending rates."
The Commerce Department reported the personal consumption expenditures (PCE) price index increased 0.2% last month after an unrevised 0.1% drop in November, and was up 2.6% year-on-year.
The core PCE price index, which excludes food and energy, increased 2.9% year-on-year, the smallest gain since March 2021, after rising 3.2% in November.
But data from the department's Bureau of Economic Analysis also showed consumer spending surged at the end of 2023, another sign of the economy's resilience despite the Fed's most aggressive rate hiking in four decades.
"The numbers right now are pretty supportive for risk and they're supportive for a soft landing," said Marvin Loh, senior global macro strategist at State Street in Boston, but adding that soft landings are still incredibly rare.
"These numbers are good," he said. However, "there are potential wage issues that might show up that make (a soft landing) a little bit more questionable."
Treasury yields rose after an initial decline in a sell-off that suggested consolidation after a recent rally as the market anticipates the Fed will soon start cutting interest rates. Treasury yields move inversely to prices.
Bets in the futures market that the Fed will cut interest rates in March slid to 47.4% from 49.1% on Thursday, according to CME Group's FedWatch Tool. But the likelihood of a rate cut in May are greater, with odds they stay the same at just 11.7%.
The yield on the 30-year Treasury bond was up 0.6 basis points to 4.387%.
The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at
2.298
%.
The 10-year TIPS breakeven rate was last at
2.298
%, indicating the market sees inflation averaging about 2.3% a year for the next decade. (Reporting by Herbert Lash; Editing by Barbara Lewis, Andrea Ricci and Leslie Adler)
