TREASURIES-US yields drift higher after stronger-than-expected services sector data

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US ISM services sector index prices paid at 2-year high

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US yield curve steepens

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US Treasury to auction 3-year notes on Monday

By Gertrude Chavez-Dreyfuss

NEW YORK, May 5 (Reuters) - U.S. Treasury yields edged higher on Monday, after data showed that the services sector in the world's largest economy remained resilient last month, with prices paid, an inflation gauge, hitting a two-year high.

Volume was lighter than usual, with financial markets closed in the U.K., Japan, Hong Kong and mainland China.

Before the data, U.S. yields were mixed with very little movement. The benchmark 10-year yield was last up 1.9 basis points (bps) at 4.339%. On the short end of the curve, the two-year yield was marginally higher at 3.843%. It was trading lower before the data. The Institute for Supply Management (ISM) said on Monday its nonmanufacturing purchasing managers index (PMI) increased to 51.6 last month from 50.8 in March. Economists polled by Reuters had forecast the services PMI dipping to 50.2.

The survey's measure of prices paid for services inputs jumped to 65.1, the highest reading since January 2023 and followed 60.9 in March.

"The increase in the prices-paid component in April doesn't exactly line up with the featured survey responses, which indicate more uncertainty than actual price increases," wrote Will Compernolle, macro strategist at FHN Financial in Chicago.

"Despite the uncertainty, the prices-paid component jumped, and is a solid leading indicator of CPI inflation. Bond yields rose in reaction to the ISM Services print partially due to the stronger-than-expected headline index, but also because higher prices paid means the Fed is more likely to remain on the sidelines for longer," Compernolle wrote.

The U.S. yield curve steepened following the data, with the spread between two-year and 10-year yields at 50 bps , compared with 48.4 bps late on Friday.

The current curve is described as a "bear steepener," in which long-term interest rates are rising more quickly than those on the short end. This often happens when inflation expectations pick up. In the current easing cycle, the market is expecting the Federal Reserve to hold interest rates unchanged at the next few meetings and not cut them, as inflation firms.

"The question on bond investors' minds is: are we going to see the tariff shock show up on hard data?," said Stan Shipley, managing director and fixed income strategist at Evercore ISI. "We are now coming up to a period where higher tariffs are going to influence consumer prices in May and June. We're getting closer to that."

Outside of the ISM data impact, the market overall struggled for direction ahead of crucial auctions this week that could once again test demand for U.S. government debt.

The U.S. Treasury will auction $58 billion in three-year notes later on Monday, $42 billion in 10-year notes on Tuesday, and $25 billion in 30-year bonds on Thursday. Of the three auctions, investors are focused more on the U.S. 10-year note sale as they remain on the lookout for signs of diminishing demand for Treasuries.

"Our expectations are that the (10-year) auction will be well sponsored by both domestic and overseas participants, as we maintain that it is still too early in the trade war to expect a meaningful rotation away from Treasuries as a reserve asset - at least not on the part of official money," wrote Ian Lyngen, managing director and head of U.S. rates strategy at BMO Capital in a research note. Monday's generally lackluster trading also comes ahead of a two-day monetary policy meeting at the Federal Reserve, which is expected to hold interest rates steady in the 4.25%-4.50% range. A solid U.S. nonfarm payrolls report for April released last Friday also gave the Fed some breathing room to stay patient with interest rates.

The benchmark federal funds futures market has priced in a more than 70% chance that the U.S. central bank will resume cutting rates at the July policy meeting, LSEG calculations showed. Overall, the market expects about 77 bps of easing this year.

In other maturities, U.S. 30-year bond yields were up 2.6 bps at 4.822%. (Reporting by Gertrude Chavez-Dreyfuss; Editing by Will Dunham)