* US producer prices unchanged in July

* US rate futures now price in just 35% chance of a rate

hike

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

* US 30-year bond auction shows lackluster results

(Updates headline and paragraph 2 to reflect auction results)

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 and paring back

expectations that the Federal Reserve will raise interest rates

at its policy meeting next month.

A lackluster U.S. 30-year bond auction briefly dented the rally.

The bond priced at 5.216%, the highest yield since 2001,

according to analysts, and slightly above market forecasts,

suggesting that investors sought a small premium to take down

the bond.

But the overall market bias remained tilted toward lower

yields. Falling yields mean bond prices are rising.

In afternoon trading, U.S. 2-year yields, which are

sensitive to the outlook for interest rate moves, fell to their

lowest since mid-July and were last down 5.7 basis points at

4.142%. The benchmark 10-year yield slid 5.3 bps to

4.639%, while the U.S. 30-year bond yield was down

3.9 bps at 5.208%.

Data showed that the U.S. Producer Price Index was unchanged

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

polled by Reuters had forecast the PPI rising 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 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 49.5 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 investors are dialing back expectations of Fed

tightening.

Consistent with that view, U.S. fed funds futures on Thursday

priced in just a 35% chance of a rate increase at the September

Fed meeting following the PPI report, down from 41% late on

Wednesday.

Traders also expected 23 bps of tightening by the end of the

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

MIDDLE EAST STILL CRUCIAL TO INFLATION

"Thursday's PPI alone doesn't change the calculus of the Federal

Reserve, as the key to taming the inflation picture right now is

a resolution in the Middle East or the establishment of

pipelines to rely less on the Strait of Hormuz, and the Fed has

no influence on that," said Glen Smith, chief investment officer

at GDS Wealth Management in Flower Mound, Texas.

"For now, the Fed is likely to keep rates steady through

year-end."

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

With the U.S. data out of the way, bond investors focused on the

auction of $25 billion in new 30-year bonds, which showed

overall middling results.

The bid-to-cover ratio, a measure of demand, was 2.39 times,

marginally down from a six-auction average of 2.43 times.

Indirect bids, which include foreign investors, took 66.8% of

supply, slightly down from the 67% average of the last six

auctions.

J.P. Morgan noted in a research note that 30-year yields have

risen about 19 bps since the July auction, citing a number of

factors including "Fed credibility concerns and rising long-end

Japanese government bond yields" pushing the back end of the

curve higher.