(Recasts headline and first paragraph; updates yields, Fed cut expectations)
By Kate Duguid
NEW YORK, Oct 4 (Reuters) - A moderate increase in U.S. job growth in September drove short-dated yields higher on Friday morning, but the move was not big enough to reverse the fall in two-year note yields this week to two-year lows on evidence of a slowdown in the national manufacturing and services sectors.
In addition to the job growth, the Labor Department reported the unemployment rate dropped to near a 50-year low of 3.5%, easing some market concerns about an imminent recession. However, the monthly report also showed wage growth stagnating and manufacturing payrolls declining for the first time in six months, evidence that the economic softness induced by the U.S.-China trade war has begun to spread to the labor market.
The data followed a string of weak economic reports earlier this week, including a plunge in manufacturing activity to a more than 10-year low in September and a sharp slowdown in services industry growth to levels last seen in 2016. These reports had sent the two-year Treasury yield, a proxy for investor expectations of moves in interest rate policy, to its lowest level since September 2017.
The two-year yield was last trading up 3 basis points to 1.416%, but remains down 20.8 basis points this week.
"I think that the overall picture confirms the gentle slowdown in the economy that is already priced into the bond market," said Kathy Jones, chief fixed income strategist at Schwab Center for Financial Research.
"It's pretty consistent with what we saw with the PMIs, the ISMs ... The drop in the manufacturing payrolls was a confirmation of softness in there."
The benchmark 10-year yield was down 1 basis point to 1.526%, pushing down the spread between two- and 10-year yields to 10.6 basis points. The spread - the traditional measure of the yield curve - was 14.2 basis points at last close, almost 10 basis points higher than where it began the week.
"All in all, it's not probably a big mover for the bond market, but it does leave the likelihood of a Fed rate cut on the table – perhaps in October, perhaps they’ll decide upon it in December and get more data," Jones said.
Expectations the Federal Reserve will cut rates later this month by 25 basis points from its current target rate of 1.75%-2.0% were at 77.5% on Friday, compared to 88.7% on Thursday and 39.6% on Monday, according to CME Group's FedWatch tool. (Reporting by Kate Duguid Editing by Nick Zieminski and Paul Simao)