TREASURIES-US yields rise after strong retail sales

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U.S. 10-year yield hits lowest since May 2023

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August retail sales surprise to upside

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U.S. 2/10 curve flattens to 5 bps

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20-year note auction meets underwhelming demand

(Updates as of 15:18 ET)

By Matt Tracy

WASHINGTON, Sept 17 (Reuters) - U.S. Treasury 10-year yields rose from 16-month lows on Tuesday after news that retail sales in the world's largest economy increased unexpectedly last month, suggesting there is no urgency for the Federal Reserve to do a supersized rate cut of 50 basis points on Wednesday.

The Fed is widely expected to cut interest rates following a two-day meeting starting on Tuesday. The size of the rate reduction, however, is still very much up in the air.

Following the retail sales data, benchmark 10-year Treasury yields fell to 3.599%, their lowest since May 2023, but subsequently rallied to their current 3.642%.

Benchmark yields hit the day's high following a 20-year note auction that was met with underwhelming demand. The 2.51-to-one bid-to-cover ratio was the lowest since May, while primary dealers, who step in when buyers are scarce, bought 18.6% of $13 billion up for sale, which is the highest percentage since February and the second most in more than three years.

"This is an indication that institutional investors pulled back risk ahead of tomorrow's Fed meeting, questioning whether the bond market is ahead of itself," said Tom di Galoma, head of fixed income trading at Curvature Securities.

On the short end of the curve, the two-year yield rose after hitting its weakest level in two years on Monday. It was last up 3.7 basis points to 3.592%.

U.S. retail sales surprisingly increased 0.1% in August, after an upwardly revised 1.1% surge in July. Economists polled by Reuters had forecast retail sales falling 0.2% last month.

After the report, U.S. rate futures priced in a 65% chance of a 50-bp easing on Wednesday, with a 35% probability of a 25-bps move, LSEG estimates showed. Futures traders have also factored in about 120 bps in cuts this year and 245 bps through September next year.

Industrial production in August similarly surprised to the upside, rebounding in August following a sharp decline in July. The NAHB Housing Market Index, a measure of homebuilder confidence, also beat market forecasts.

The yield on the 30-year bond was last up 1.4 basis points at 3.951% after earlier dropping to its lowest since July 2023 at 3.898%. "We're not seeing anything significant. I still think it's kind of a wait-and-see," said di Galoma. "I think people are really very unsure what the Fed's going to do here, so I don't think we're going to see very much happening until two o'clock tomorrow," he said.

Most economists expect the U.S. central bank to cut rates by 25 bps on Wednesday, according to a Reuters poll, arguing that the economy is not in distress to warrant the half-percentage-point reduction being anticipated by financial markets.

"We think the economy will remain solid, so we anticipate a measured easing cycle from the Fed, in contrast to the rapid cuts priced in by markets," said Michael Pearce, deputy chief U.S. economist at Oxford Economics.

The U.S. yield curve flattened after the data, with the yield spread between two- and 10-year notes narrowing to 5 bps , compared with 6.5 bps late on Monday. The slight flattening of the curve suggested the market has modestly reduced rate cut expectations.

The latest initial jobless claims figures will come on Thursday after the Fed meeting, followed by services and manufacturing sector data on Monday.

The 10-year TIPS breakeven rate was last at 2.108%, indicating the market sees inflation averaging about 2.1% a year for the next decade. (Reporting by Matt Tracy; Editing by Gertrude Chavez-Dreyfuss and Jonathan Oatis)