TREASURIES-U.S. yields drop to three-month lows as markets prep for smaller Fed hikes

(Adds comment, bullets, updates prices) * U.S. 5-year to 30-year yields hit three-month lows * Focus on Fed policy meeting next week * Fed pause is best chance for soft landing -analyst By Gertrude Chavez-Dreyfuss NEW YORK, Dec 7 (Reuters) - U.S. Treasury yields from five-year notes to 30-year bonds fell to three-month lows on Wednesday in choppy trading, with few market drivers this week, as investors doubled down on bets that interest rates have likely peaked and inflation has moderated. "We have been kind of in a strong rally and we haven't been given much of a pullback to get in," said Ellis Phifer, managing director of fixed income research at Raymond James in Memphis, Tennessee. "The bond market sees inflation waning; the Fed chair also confirmed that the Fed is ... slowing and the bond market is happier and bullish with that thought process." That said, strong November U.S. jobs data and generally upbeat reports on manufacturing and services suggest the Fed still has a long way to go to tame consumer and wage inflation pressures. Fed Chair Jerome Powell said late last month the U.S. central bank could ease the pace of rate hikes "as soon as December" but warned that the fight against inflation was far from over. That has prompted the market to price in a lower terminal rate, or the peak rate at which the Fed will stop hiking. Fed funds futures showed that the peak rate on Wednesday was 4.9%, down from 5.1% last week before Powell spoke. U.S. Treasury rates trended lower as well, with the U.S. benchmark 10-year yield dropping 38 basis points (bps) since Powell's remarks on Nov. 30. The U.S. two-year yield, which typically reflects interest rate expectations, has fallen nearly 31 bps since then. "The market was very short (Treasuries) heading into December and they're getting less short now after the last CPI (consumer price index) report," said Gennadiy Goldberg, senior rates strategist at TD Securities in New York. "There's a lot of uncertainty out there and that's why we're seeing this daily chop because investors don't really know what to do next." A widely tracked part of the U.S. Treasury yield curve measuring the gap between yields on two- and 10-year notes deepened its inversion to -85.20, the most in two weeks. The inversion of this curve typically precedes recession. In afternoon trading, the yield on 10-year notes was down 9.8 bps at 3.415%. Earlier in the session, it fell as low as 3.402%, the lowest since September. U.S. 30-year bond yields slid 10.1 bps to 3.422%, after sinking to 3.412%, a three-month trough. On the shorter-end of the curve, the two-year U.S. Treasury yield fell 9.8 bps to 4.262%. The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) retreated to 2.3796% from 2.443% on Tuesday, suggesting inflation will average roughly 2.3% over the next five years. Since Nov. 7, five-year breakevens have fallen around 25 bps. The 10-year TIPS breakeven rate was last at 2.278%, down from Tuesday's 2.339%. The Fed is widely expected to raise rates by 50 bps next week. "I think the Fed is going to do 50 (bps) in the next two meetings and then maybe pause and see what happens," Raymond James' Phifer said. "As long as inflation does not trend higher again, the Fed could be on pause and just wait for other data. That's the Fed's best chance to get a soft landing." December 7 Wednesday 4:27PM New York / 2127 GMT Price Current Net Yield % Change (bps) Three-month bills 4.19 4.2937 -0.077 Six-month bills 4.535 4.7059 -0.032 Two-year note 100-111/256 4.2685 -0.092 Three-year note 101-96/256 3.9982 -0.094 Five-year note 101-24/256 3.6327 -0.101 Seven-year note 101-252/256 3.5513 -0.096 10-year note 105-220/256 3.4241 -0.089 20-year bond 104-172/256 3.6674 -0.091 30-year bond 110-152/256 3.4309 -0.092 DOLLAR SWAP SPREADS Last (bps) Net Change (bps) U.S. 2-year dollar swap 32.25 1.50 spread U.S. 3-year dollar swap 11.25 1.00 spread U.S. 5-year dollar swap 3.75 2.00 spread U.S. 10-year dollar swap -3.25 2.25 spread U.S. 30-year dollar swap -38.50 2.75 spread (Reporting by Gertrude Chavez-Dreyfuss; Editing by Elaine Hardcastle and Richard Chang)