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PCE data shows inflation stuck above Fed's target

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Core PCE higher than forecast, reviving stagflation fears

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Consumer sentiment drops to two-year low - survey

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10-year yield posts biggest daily drop in over a month

(Updates market levels, adds details, investor comments,

graphic)

By Davide Barbuscia

NEW YORK, March 28 (Reuters) - U.S. Treasury yields

tumbled on Friday as investors assessed the likely negative hit

on growth from President Donald Trump's tariffs alongside

inflation persistently stuck above the Federal Reserve's goals.

A Commerce Department report showed that the Personal

Consumption Expenditures Price Index increased as expected by

economists surveyed by Reuters. However, excluding volatile

components like food and energy, the index rose 2.8%

year-over-year in February, exceeding the forecast 2.7% gain,

while consumer spending rebounded after declining in January.

Meanwhile, a wave of reciprocal tariffs Trump plans to

unveil next week continued to loom large over markets, with

investors nervous over the extent of the import duties in the

final policy.

"The bond market and markets in general are consternating

about the softer growth versus higher and persistent inflation,"

said George Cipolloni, portfolio manager at Penn Mutual Asset

Management. "The PCE number today was more of a stagflation

print ... That's not the best environment to be in."

Stagflation is a mix of sluggish growth and relentless

inflation that haunted the U.S. in the 1970s. With the threat of

more tariffs, "it feels like it (stagflation) is going to be

more and more likely of an outcome, in terms of a slower growth

and high-cost type of environment," said Cipolloni.

The Personal Consumption Expenditures (PCE) price index

increased 0.3% in February, in line with forecasts, after

advancing by an unrevised 0.3% in January. In the 12 months

through February, prices increased 2.5%, matching January's

rise.

Treasury yields, which move inversely to prices and were

already lower on the day, edged higher immediately after the PCE

data but then pared back those increases and kept declining.

The bond rally gained more momentum after the release of a

University of Michigan survey showing consumer sentiment dropped

in March to a more than two-year low, while long-run inflation

expectations topped 4%, double the Fed's target.

"In theory tariffs should be a one-time price increase,

but ... consumers are not making that distinction and are

assuming these higher prices are going to continue into the

future for quite some time," said Ayako Yoshioka, portfolio

consulting director at Wealth Enhancement Group.

"For the bond market the focus really is on the growth

scare we're getting and whether this is going to turn into

something else," she added.

Traders in interest rate futures anticipated a more

accommodative Federal Reserve, betting on a total of about 73

basis points in interest rate cuts this year, around 10 basis

points more than before the PCE release, according to LSEG data.

San Francisco Fed President Mary Daly

said on Friday

she still saw two interest-rate cuts this year as a

"reasonable" projection, though the central bank could wait to

cut rates to assess how businesses adjust to tariff costs.

"This elevated inflation places the Fed in a challenging

position regarding future rate policy," Matt Stephani, president

of Cavanal Hill Investment Management, said in emailed comments.

"While the economy appears solid, business executives

are adopting a cautious stance on new investments, largely due

to the Trump administration's aggressive and unpredictable

tariff policy," he said.

Benchmark 10-year yields were last at 4.255%,

over 11 basis points lower on the day - the biggest one-day drop

since February 13. Two-year yields, which reflect

expectations of shorter-term changes in monetary policy, shed

about nine basis points, their biggest daily drop since March

10, and were last at 3.908%, the lowest in over two weeks.

The closely watched part of the yield curve that plots the

premium of 10-year yields over two-year yields was at about 34

basis points, slightly flatter than on Thursday.