TREASURIES-US yields sink after soft payrolls boost chances of September rate cut

(Adds new comment, more US data, graphic, updates yields)

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US two-year yields drop to lowest in five weeks

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Fed seen as likely to cut rates in September, futures show 81% chance

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Manufacturing PMI contracts for fifth month, factory employment hits five-year low

By Gertrude Chavez-Dreyfuss

NEW YORK, Aug 1 (Reuters) - U.S. Treasury yields plunged after data showed on Friday the world's largest economy created fewer jobs than expected in July, increasing the odds that the Federal Reserve will resume cutting interest rates at its September meeting.

U.S. two-year yields, which are tied to the Fed's monetary policy, dropped 21 basis points to 3.743%, on track for their largest daily fall in two years. The yield also dropped to its lowest since June 30.

The benchmark 10-year yield also fell to a five-week trough and was last down 11.9 bps at 4.241%. It was on pace for its biggest one-day decline since mid-April. Data showed U.S. job growth slowed more than expected last month, while June's data was revised sharply lower, pointing to a sharp moderation in the labor market.

Nonfarm payrolls increased by 73,000 jobs last month after rising by a downwardly revised 14,000 in June, data showed. Economists polled by Reuters had forecast payrolls increasing by 110,000 jobs after rising by a previously reported 147,000 in June. May was also revised downward.

The unemployment rate rose to 4.2% from 4.1% in June.

"The Fed is caught between above-target inflation and the uncertain impact of tariffs on the inflation picture moving forward with a clearly slowing labor market," said Chip Hughey, managing director of fixed income at Truist Advisory Services in Richmond, Virginia.

"Today complicates things further in that the labor market, which was already cooling, and I think the Fed had even already acknowledged that the labor market was cooling. Obviously, (labor market concerns) accelerated with today's report, but the Fed remains caught between the two sides of its dual mandate. So you're seeing a sharp bull steepening in the yield curve, and you're seeing expectations for a September rate cut." The yield curve bull steepened after the jobs report, with the gap between two-year and 10-year yields widening to 43 bps US2US10=TWEB to as much as 51.6 bps, the highest gap since July 23, compared with 41.5 on Thursday. The curve was last at 49.6 bps.

A bull steepener refers to a scenario in which shorter-dated yields are falling much faster than those on long maturities, which reflects expectations that the Fed will cut soon.

U.S. rate futures have now priced in an 81% chance that the Fed will cut rates in September, according to the CME's FedWatch. That chance was just 38% late Thursday. Rate futures have also factored in 58 bps of easing this year, compared with just 39 bps of rate declines on Thursday. Fed Governor Christopher Waller and Fed Vice Chair for Supervision Michelle Bowman were two dissenting governors to Wednesday's decision by the Federal Reserve Open Committee to keep rates unchanged in the 4.25%-4.50% target range. They said on Friday they did so largely due to rising concerns about the job market, in statements made public just ahead of the release of hiring data that bolstered their position.

Treasury yields further declined after data showed U.S. manufacturing contracted for a fifth straight month in July and factory employment dropped to the lowest level in five years amid tariffs that have raised prices of imported raw materials. The Institute for Supply Management said on Friday its manufacturing PMI last month from 49.0 in June. A PMI reading below 50 indicates contraction in manufacturing, which accounts for 10.2% of the economy. Economists polled by Reuters had forecast the PMI edging up to 49.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Toby Chopra, Rod Nickel)