(Adds data, analyst comment, byline, fed funds futures; updates

yields)

* US producer prices unchanged in July

* US rate futures now price in just 32% chance of a rate

hike

* US 2/10 yield curve hits steepest level since May

* Focus on US 30-year bond auction

By Gertrude Chavez-Dreyfuss

NEW YORK, Aug 13 (Reuters) - U.S. Treasuries rallied on

Thursday after data showed tame producer prices in July,

generally coming in line with market forecasts, paring back

expectations that the Federal Reserve will raise interest rates

at its policy meeting next month.

In morning trading, U.S. two-year yields, which are sensitive to

the outlook for interest rate moves, fell to their lowest since

mid-July and were last down 6.2 basis points (bps) to 4.136%

. Falling yields mean bond prices are higher.

The benchmark 10-year yield slid 6.3 bps to 4.629%,

while the U.S. 30-year bond yield was down 5 bps at 5.196%

.

Data showed that the U.S. Producer Price Index (PPI) was

unchanged last month, following a revised 0.1% drop in June.

Economists polled by Reuters had forecast the PPI rebounding

0.2%.

In the 12 months through July, the PPI increased 4.7% after

advancing 5.5% in June. The forecast was for a 4.9% increase

year-on-year.

"It's a continuation of the kind of story that we've seen

playing out recently, which is prices do seem to be coming down

incrementally, or inflation is decelerating incrementally," said

Bill Merz, head of capital markets research and portfolio

construction at U.S. Bank Asset Management in Minneapolis.

"At the same time, the price pressures that do exist haven't

been crimping consumer spending, haven't been crimping or

limiting earnings growth that we're seeing across the global

capital markets."

In other parts of the Treasury market, the yield curve

steepened following the PPI data, with the gap between 2-year

and 10-year yields hitting 50.6 bps, the widest

spread since May 22. It was last at 48.3 bps, compared with 48.9

bps late Wednesday.

The curve showed a bull steepener, in which short-term interest

rates are dropping more sharply than longer-dated ones,

suggesting that the market is pricing out Fed tightening.

This scenario is backed by the U.S. rate futures market.

Following the PPI report, U.S. fed funds futures priced in on

Thursday just a 32% chance of a rate increase at the September

Fed meeting, down from 41% late on Wednesday.

Traders also expected 24 bps of tightening by the end of the

year after the data, compared with 27 bps on Wednesday.

Thursday's data also showed U.S. initial jobless weekly claims

increased modestly, suggesting that the labor market remains

stable despite July's surprise job losses.

Initial claims for state unemployment benefits rose 9,000 to a

seasonally adjusted 209,000 for the week ended August 8,

according to the Labor Department. Economists polled by Reuters

had forecast 202,000 claims for the latest week.

The report added to expectations that the Fed will remain on

hold at the September meeting.

Also on Thursday, the Treasury is set to auction $25 billion in

new 30-year bonds. In the when-­issued market, where the bond is

traded before it is actually sold, the new debt has a projected

yield of around 5.18%.

Vail Hartman, U.S. rates strategist at BMO Capital, wrote in a

research note that the sale would be the highest-yielding

30-year auction in several decades.

"On top of the substantial outright discount, valuations look

solid on the curve," he added.