TREASURIES-US yields drop after service sector data, political headlines

(Adds context in 7th paragraph, updates yield curve, milestone for 10-year yield)

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US 10-year yield hits lowest since mid-December

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US two-year yield falls to lowest since December 12

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US two/10-year curve flattens, narrowest gap since December 23

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US Treasury keeps auction sizes unchanged in refunding statement

By Gertrude Chavez-Dreyfuss

NEW YORK, Feb 5 (Reuters) - U.S. Treasury yields declined to multi-week lows on Wednesday, weighed down by a weak report on the services sector, with investors continuing to grapple with persistent uncertainty about President Donald Trump's tariff policy and the prospect of trade wars. Trump's proposal for the U.S. government to take over war-torn Gaza and create the "Riviera of the Middle East" after resettling Palestinians elsewhere fueled confusion and global criticism and sparked safe-haven bids for Treasuries.

"Trump's proposal to take over Gaza has triggered flight to safety trades," said Will Compernolle, macro strategist at FHN Financial in Chicago. "That comment creates the risk of escalating a wider regional conflict." Further adding to Wednesday's bond-bullish environment was the U.S. Treasury's refunding announcement that showed no auction increases in notes and bonds through the April quarter, as expected. But its impact was felt by what it did not say.

The Treasury, which has kept auction sizes unchanged since August 2023, did not provide guidance on when they will increase them. Treasuries showed little reaction to the refunding statement, although did contribute to yields staying lower on Wednesday, analysts said.

With steady debt auction sizes for the next several quarters, the bond market would be able to absorb the supply of new Treasuries smoothly.

An increase in debt supply in a situation in which the biggest bond buyer - the Federal Reserve - will not be there to backstop the market could lift Treasury yields further, analysts said.

The benchmark 10-year yield dropped to its lowest since mid-December. It was last down 8.9 basis points (bps) at 4.426% , its biggest daily fall since late January. U.S. 30-year yields sank 10 bps to 4.649% after earlier falling to its lowest since December 18.

On the short end of the curve, the two-year yield also tanked, sliding to its weakest since December 12. It last changed hands at 4.187%, down 2.7 bps.

The drop in yields came after data showed the U.S. services sector activity unexpectedly slowed in January. The Institute for Supply Management's (ISM) non-manufacturing purchasing managers index (PMI) slipped to 52.8 last month from 54.0 in December. Economists polled by Reuters had forecast the services PMI edging up to 54.3. The ISM data offset a fairly strong U.S. private sector jobs report. Private payrolls increased by 183,000 jobs last month after an upwardly revised 176,000 rise in December. Economists polled by Reuters had forecast private employment advancing by 150,000.

TARIFFS AND TRADE WARS

The risk of tariffs and trade wars, however, remains a lingering market threat, even though noise on those fronts has eased a bit.

"The trade war is the recent thing driving yields," said Kathy Jones, chief fixed income strategist at Schwab in New York. "We've had the big threat of tariffs and that hasn't really materialized, at least for the moment ... But it's really a day-by-day, a minute-by-minute assessment of the outlook." The uncertain outlook on tariffs came as the U.S. trade deficit widened sharply in December. Imports surged to a record high amid the backdrop of tariff threats.

The trade gap increased 24.7% to $98.4 billion, the highest since March 2022, from a revised $78.9 billion in November, data showed. The rise was the largest since March 2015. Imports, on the other hand, increased 3.5% to a record $364.9 billion.

The United States posted significant deficits with several trade partners, including China, Mexico and Canada, which have been targeted by Trump for broad or additional tariffs. Trump on Monday suspended 25% tariffs on Mexican and Canadian goods until next month.

An additional 10% levy on goods from China went into effect on Tuesday. China, the world's second-largest economy, slapped duties on U.S. goods as well, although they will not take effect until February 10.

In other parts of the bond market, the yield curve flattened, with the gap between two-year and 10-year yields hitting 23 bps, from 29.5 bps in the previous session.

Wednesday's curve hit its narrowest spread since December 23, with traders describing it as a bull flattener, a scenario in which long-term rates are falling faster than short-dated ones. The curve flattening reflects concerns about growth and inflation that could prompt the Fed to hold interest rates unchanged for longer.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Nick Zieminski, Will Dunham and Daniel Wallis)