TREASURIES-Yields fall as May inflation data come in lower than feared

* Monthly PCE inflation rose 0.4% in May, below economists' 0.5% forecast

* Five-year breakeven rates fell to around 2.20%, their lowest level this year

* US Treasury will sell $44 billion in 7-year notes on Thursday

By Karen Brettell

NEW YORK, June 25 (Reuters) - U.S. Treasury yields fell on Thursday after inflation data for May came in slightly softer than some investors had feared, offering a measure of relief even as Federal Reserve policymakers weigh whether further interest rate increases will be needed to bring prices under control. The Personal Consumption Expenditures Price Index - the Fed's preferred inflation gauge - rose at a seasonally adjusted 4.1% annual rate in May, the highest reading since April 2023. It gained 0.4% on the month, below economists' expectations for an increase of 0.5%.

Excluding food and energy, the core index rose 3.4% annually after climbing 0.3% for the month, both in line with consensus forecasts.

"Today's numbers are not hugely concerning," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia.

"I don't think we're through the woods in terms of pass-through from higher energy prices into core inflation. That's probably going to take until July or August to really see the full effects of that. But it is very marginally not as bad as feared," LeBas added. Oil prices have tumbled to four-month lows as a deal to end the U.S.-backed war with Iran appears close, but energy price disruptions are expected to last for several more months. The 2-year note yield, which typically moves in step with Fed interest rate expectations, fell 3.67 basis points to 4.098%, the lowest level since June 17.

The yield on benchmark U.S. 10-year notes fell 3.14 basis points to 4.367%, the lowest level since May 8.

The yield curve between 2- and 10-year notes steepened to 26.9 basis points. Longer-dated Treasury yields have fallen while shorter-dated yields remain relatively elevated since the Fed's June 16-17 meeting showed that its policymakers expect a hike in borrowing costs later this year amid growing concerns about inflation that is lodged above the U.S. central bank's 2% target. New Fed Chairman Kevin Warsh also signaled a shift away from forward guidance by withholding his projection from the central bank's "dot plot" chart, adding to uncertainty about the outlook.

"The markets are pricing in a chance of more risk in the front-end and the risk is one-sided," LeBas said. "Right now, the inflation data are biased to the high side, so less guidance means risk to the high side."

TREASURY TO SELL $44 BILLION IN 7-YEAR NOTES

Fed funds futures traders are pricing in 59% odds of a hike by September, down from 62% before the release of the data on Thursday.

Some analysts say the Fed's more hawkish turn at last week's meeting has helped to dispel the worst inflation fears - particularly the concern that Warsh might push for looser policy. "There was a question until last week - was Warsh going to come in and push for lower rates, and in that scenario, then inflation expectations might become unanchored," said Molly Brooks, U.S. rates strategist at TD Securities. "He didn't really do that. The fact that the Fed is willing to hike actually supported the inflation expectations."

Five-year breakeven rates, which measure expected annual inflation over the next five years, have fallen to their lowest levels this year at around 2.20%.

The Treasury Department will sell $44 billion in 7-year notes on Thursday, the final sale of $183 billion in short- and intermediate-term coupon-bearing debt this week.

The U.S. government saw soft demand for a $70 billion sale of 5-year notes on Wednesday and good demand for a $69 billion sale of 2-year notes on Tuesday. (Reporting by Karen Brettell; Editing by Paul Simao)