(New throughout, adds analyst quote)
By Kate Duguid
NEW YORK, Oct 3 (Reuters) - U.S. bonds rallied for the sixth straight session on Thursday, leaving the two-year Treasury yield at its lowest since September 2017, as signs of a slowdown in U.S. manufacturing and services fanned recession fears.
The Institute for Supply Management (ISM) said its index of non-manufacturing activity fell to 52.6 in September from 56.4 the previous month. The reading was below expectations of 55.0 from a Reuters poll of 67 economists and was the lowest since August 2016. The survey of purchasing managers also showed the weakest job growth in half a decade in the largest slice of the U.S. economy.
Yields across maturities were lower going into Friday's nonfarm employment report, which will show whether the manufacturing and services slowdown has spread to the labor market. The two-year Treasury yield, which reflects investor expectations of interest rate moves, fell 10.2 basis points to 1.382%, extending a 7.2 basis point fall on Wednesday.
"The data so far this week has certainly offered a cautious picture for the domestic economy in September and a bullish tailwind for Treasuries. As such, the implications for Friday's jobs release are significant to either support or refute a downshift in hiring trends," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.
Expectations the Federal Reserve will cut rates in October by 25 basis points from its current target rate of 1.75%-2.0% jumped to 88.2% on Thursday from 39.6% on Monday, according to CME Group's FedWatch tool.
An October rate cut "is certainly a possibility but it is still not our baseline," said Michael Pond, head of global inflation-linked research at Barclays. "But the Fed is certainly data-dependent and if that data weakens enough, then they will respond."
"We do continue to see the Fed as reactive rather than proactive, which is why even though the market was pricing in a greater chance of Fed cuts, we are not seeing that translate into higher inflation expectations," Pond said.
Thursday's data followed an Institute for Supply Management survey on Tuesday that showed national factory activity tumbled to more than a 10-year low in September, as U.S.-China trade tensions strained business conditions. National factory activity fell to 47.8. A reading below 50 signals the sector is contracting.
The benchmark 10-year Treasury yield was last down 6.8 basis points at 1.529%, with the 30-year bond yield last down 5.3 basis points at 2.034%.
Reporting by Kate Duguid; Editing by Dan Grebler and Richard Chang