By Herbert Lash Jan 22 (Reuters) - Bond traders dialed back their expectations for inflation on Friday following run-up in the prior session as U.S. Treasury yields dipped and the yield curve flattened. Treasury yields traded lower after a strong auction on Thursday of $15 billion in 10-year TIPS as investors sought protection on expectations of rising inflation. The benchmark 10-year yield was last down 1.1 basis points at 1.096% as prices eased a bit from earlier highs. A closely watched part of the yield curve measuring the gap between yields on two- and 10-year Treasury notes was last down 1.32 basis points at 96.93 basis points. The inflation breakeven rate for 10-year Treasury Inflation-Protected Securities (TIPS) dropped after climbing to 2.182%, its highest level since May 2018, after Thursday's auction of $15 billion in the securities. The TIPS breakeven rate was last at 2.03%. The breakeven rate indicates the market expects inflation to average more than 2% a year for the next decade, above the current pace of inflation. TIPS are popular now, similar to 2011, with inflation a topic of market interest, said Jake Remley, senior portfolio manager at Income Research + Management in Boston. "We see liquidity much better these days in TIPS. You see fast money engaged in the sector and dealers really wanting to make markets and be a preferred vendor for TIPS," he said. A surge in U.S. manufacturing activity to its highest level in more than 13-1/2-years in early January showed bottlenecks in the supply chain caused by the COVID-19 pandemic are driving up prices and signaling a rise in inflation in the months ahead. Data firm IHS Markit said its flash U.S. manufacturing PMI accelerated to a reading of 59.1 in the first half of this month, the highest since May 2007, from 57.1 in December. Economists had forecast the index slipping to 56.5 in early January. The two-year U.S. Treasury yield, which typically moves in step with interest rate expectations, was last down less than a basis point at 0.123%. January 22 Friday 10:52AM New York / 1552 GMT Price Current Net Yield % Change (bps) Three-month bills 0.075 0.0761 -0.005 Six-month bills 0.085 0.0862 -0.005 Two-year note 100-1/256 0.123 -0.002 Three-year note 99-208/256 0.1883 -0.003 Five-year note 99-174/256 0.4407 -0.006 Seven-year note 99-6/256 0.77 -0.010 10-year note 97-244/256 1.0957 -0.011 20-year bond 95-36/256 1.664 -0.013 30-year bond 94-164/256 1.86 -0.011 DOLLAR SWAP SPREADS Last (bps) Net Change (bps) U.S. 2-year dollar swap 7.75 0.25 spread U.S. 3-year dollar swap 7.75 0.00 spread U.S. 5-year dollar swap 9.00 0.75 spread U.S. 10-year dollar swap 1.75 1.00 spread U.S. 30-year dollar swap -25.00 1.00 spread (Reporting by Herbert Lash with additional reporting by Karen Pierog in Chicago Editing by Mark Heinrich)