TREASURIES -US yields increase as uncertainty weighs on Trump's tax legislation

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Fiscal concerns overshadow potential Fed rate cut

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Republicans face challenges passing tax-cut bill

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Yield curve steepens amid fiscal worries

By Gertrude Chavez-Dreyfuss

NEW YORK, July 2 (Reuters) - U.S. Treasury yields were modestly higher on Wednesday as fiscal concerns about President Donald Trump's tax and spending legislation seemingly upstaged the likelihood of a Federal Reserve rate cut following an unexpected drop in private-sector jobs last month.

"The focus is shifting back to deficit spending and the potential for inflation to rise," said Zachary Griffiths, head of investment grade and macro strategy at CreditSights in Charlotte, North Carolina. "I feel like the overall labor market data this week has been inconsistent with JOLTS (Job Openings and Labor Turnover Survey), which came out relatively strong yesterday and then ADP (private sector jobs report). So tomorrow's nonfarm payrolls print will be key." Republicans in the House of Representatives, meanwhile, teed up a procedural vote on Trump's massive tax-cut and spending bill that could reveal whether the party has enough support to pass it out of Congress. With only three votes to spare, it was not clear whether Republicans would be able to resolve the concerns of a handful of members who have threatened to vote against the legislation. A procedural vote was set for early afternoon, with a vote on final passage possible later in the day.

In afternoon trading, U.S. two-year yields, which track interest rate expectations, rose 1.2 basis points (bps) to 3.787% after earlier trading lower. The benchmark 10-year yield, on the other hand, came off highs following the report, but was last up 5.5 bps at 4.304%. U.S. rates reacted to data showing private payrolls dropped by 33,000 jobs last month after a downwardly revised 29,000 increase in May, according to the ADP National Employment Report. That was the first drop in more than two years. Economists polled by Reuters had forecast private employment increasing by 95,000 following a previously reported gain of 37,000 in May.

"The ADP report increased the odds of a downside surprise in Thursday's nonfarm payroll release," wrote Jeffrey J. Roach, chief economist at LPL Financial, in emailed comments after the data.

"Investor jitters could be a catalyst for a drop in yields tomorrow if the jobs report is weaker than expected. I expect a weaker-than-consensus report, increasing the odds the Fed cuts three times this year."

A Reuters poll showed that economists expected 110,000 new jobs in June, down from 139,000 in May. The unemployment rate was expected to have crept higher to 4.3%, from 4.2% the previous month.

Futures tied to the benchmark fed funds rate, on the other hand, lifted the chances of a rate cut by the July policy meeting, pricing in as much as a 27% chance of a July cut post-jobs data, according to LSEG estimates. It was last at 23%, compared with a roughly 20% chance just before the data release.

For the September meeting, the market has fully priced in a 25-bp rate decline. In other parts of the bond market, the yield curve steepened, with the spread between the two-year and 10-year yield rising to 51.1 bps US2US10=TWEB from 46.7 bps late on Tuesday. This suggests that bond investors are fleeing the long end of the curve due to U.S. fiscal worries.

(Reporting by Gertrude Chavez-Dreyfuss in New York; Editing by Andrew Heavens, Chizu Nomiyama and Matthew Lewis)