TREASURIES-Two-year yields heading for largest monthly drop in a year

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Two-year yields heading for largest monthly drop in a year

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PCE data matches economists expectations for July

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Position squaring, month end push yields higher on Friday

By Karen Brettell

Aug 29 (Reuters) - U.S. Treasury yields rose on Friday though interest rate-sensitive two-year yields were on track for their largest monthly drop in a year as traders squared positions ahead of Monday's Labor Day holiday and with inflation data for July meeting economists' expectations.

The Personal Consumption Expenditures (PCE) Price Index increased 0.2% last month after an unrevised 0.3% rise in June, data on Friday showed. Excluding the volatile food and energy components, the PCE Price Index increased 0.3% last month, matching the rise in June.

The data keeps the Federal Reserve on track to cut rates at its September 16-17 meeting, as is widely expected.

"You can check this off as one more risk to potentially derailing a cut in September. The inflation part of it, at least in this measure, is not going to do anything to reduce odds of a cut in September," said Michael Lorizio, head of U.S. rates trading at Manulife Investment Management in Boston.

Fed funds futures traders are now pricing in 89% odds of a cut next month, up from 84% before the data.

Traders ramped up bets on more cuts after Fed Chair Jerome Powell last Friday adopted an unexpectedly dovish tone and said that risks to the job market were rising.

Efforts by U.S. President Donald Trump to fire Fed Governor Lisa Cook also raised the prospect that Trump could make more dovish appointments to the U.S. central bank that then result in easier policy.

A federal judge on Friday will consider whether to block Trump temporarily from firing Cook while she pursues a lawsuit claiming Trump has no valid reason to remove her.

Still, yields edged higher on Friday as traders closed positions ahead of the long weekend and repositioned for month end.

Some interest rate hedging was also likely influencing the market with corporate debt markets expected to pick up next week when many people return from summer vacations.

"We have a very busy week coming up next week with primary markets and all the spread product markets returning in full force, especially the corporate bond market," said Lorizio.

Jobs data for August is also due next Friday, which may be key in determining near-term Fed policy.

The 2-year note yield was last up 0.2 basis points on the day at 3.637%. It has fallen 32 basis points this month, the most since last August.

The yield on benchmark U.S. 10-year notes rose 2.3 basis points to 4.23%.

The yield curve between two-year and 10-year notes was last at 57 basis points. It has steepened by 16 basis points this month, the most since April.

(Reporting by Karen Brettell, Editing by Nick Zieminski)