NEW YORK, Sept 12 (Reuters) - U.S. Treasury yields drifted lower on Wednesday after data showed the first drop in August producer prices in 1-1/2 years and ahead of an auction of $23 billion in new supply of 10-year notes.
Treasury prices rallied modestly after the Labor Department reported that the producer price index fell unexpectedly last month, as declines in the prices of food and a range of trade services offset the higher cost of energy products.
Yields typically fall in step with inflation, as expectations ease that the Federal Reserve will raise interest rates to cap inflation.
The market's response on Wednesday was muted, however, because overall inflation is steadily rising, driven by a tightening labor market and robust economy. The Fed is expected to raise interest rates later this month for the third time this year.
The two-year yield, which reflects market expectations of Fed interest rate hikes, was slightly off the decade peak hit on Tuesday, and was last at 2.740 percent.
The U.S. bond market's gauge of investors' inflation outlook - the yield spread between 10-year Treasury inflation-protected securities and benchmark 10-year notes - held its earlier gains even after the PPI data, up 0.2 basis point from Tuesday, last at 2.12 percent.
The market will be awaiting the release of consumer price index data on Thursday to see if it confirms the increased inflation expectations suggested by strong job opening numbers reported on Tuesday and wage gains reported last Friday.
Later on Wednesday, $23 billion of 10-year notes will be auctioned by the Treasury Department.
The offering is lower than the $26 billion auctioned in August, but still above the average offer at that maturity of $21 billion, said Justin Hoogendoorn, head of fixed income strategy at Piper Jaffray in Chicago, Illinois.
New supply of Treasuries has surged in 2018 as the Fed has reduced its bond buying and the Treasury has issued new debt to pay for President Donald Trump's $1.5 trillion tax cut.
"One of the things we're looking at as the Treasury builds up supply, is how the market soaks that up," said Hoogendoorn.
At 10:24 a.m. ET (14:24 p.m. GMT) the 10-year yield was at 2.961 percent, down from Tuesday's close at 2.979 percent. The 30-year yield was last at 3.107 percent, below its last close at 3.124 percent.
(Reporting by Kate Duguid; Editing by Bernadette Baum)