Adds outcome of US 3-year note auction, new US-Iran development, updates yields

By Gertrude Chavez-Dreyfuss

NEW YORK, July 7 (Reuters) - U.S. Treasuries slid on Tuesday as investors kept a close watch on geopolitical tensions after attacks in and around the Strait of Hormuz drove oil prices higher, while bracing for hefty auctions this week that are expected to gauge appetite for U.S. government debt.

Treasury yields, which move inversely to prices, slightly pared their increase after a solid U.S. 3-year note auction that saw record low dealer takedown, according to BMO Capital, which is a sign that investor demand was strong enough to absorb most of the supply.

The Treasury will also auction $72 billion in 17-week bills and $39 billion in 10-year notes on Wednesday. On Thursday, it will sell $195 billion in 4-week and 8-week bills as well as $22 billion in 30-year bonds.

Against that backdrop, the benchmark 10-year yield rose to a four-week peak of 4.545% US10YT=RR and was last up 5.6 basis points (bps) at 4.535%. U.S. 30-year yields also hit a four-week high and last changed hands at 5.044% US30YT=RR, up 5 bps.

U.S. yields advanced earlier in the session in the wake of reports that Iran fired missiles at ships in the critical Strait of Hormuz waterway, analysts said, lifting oil prices and endangering a key peace memorandum of understanding between the U.S. and Iran.

They extended their rise after the U.S. revoked a general license that authorized the sale of Iranian oil, a U.S. official said on Tuesday, after three tankers reported being struck by unknown projectiles in and near the vital waterway in recent days. The news further raised oil prices in the afternoon session.

U.S. crude futures were 3.9% higher on Tuesday at $71.27 per barrel CLc1. Elevated energy costs threaten to keep inflationary pressures alive, potentially delaying the Federal Reserve's push to bring inflation back to target if peace talks break down.

Stan Shipley, fixed-income strategist at Evercore in New York, said Iran's action "changes the mood in the Treasury market," with yields accelerating their move higher in response to an increase in oil prices.

On the front end of the curve, U.S. 2-year yields, which reflect interest rate expectations, rose 4.7 bps to 4.172% US2YT=RR, gaining after two days of declines.

The yield curve initially steepened for a fifth consecutive session, with the gap between 2-year and 10-year yields widening to as much as 37.8 bps >, the highest spread in three weeks. But the curve held at 35 .9 bps in afternoon trading, little changed from 35.5 bps late on Monday.

The curve showed a bear steepening move, where longer-dated yields are rising more sharply than those on short-term maturities, reflecting a reduction in Fed rate hike bets.

U.S. rate futures on Tuesday priced in a 69.4% chance of a rate increase by the U.S. central bank's October 27-28 policy meeting, down from about 75% a week ago, according to the CME Group's FedWatch tool.

HEAVY SUPPLY

The market is also looking to heavy Treasury supply this week. Ahead of bill and note auctions, investors often sell Treasuries to push yields higher before buying them back at lower prices once new supply is absorbed — a process known in the market as building a concession.

On Tuesday, the Treasury sold $142 billion in U.S. six-week and 52-week bill auctions as well as $58 billion in three-year notes.

The U.S. 3-year note auction was well-received, priced at a lower-than-expected 4.179%, suggesting demand was strong enough that investors did not require a yield concession to take down the note.

Following the sale, the U.S. 3-year yields marginally reduced their rise, but later increased again in line with the broad market. They were last up 6.1 bps at 4.208% US3YT=RR.

In a research note before the 3-year note auction, Vail Hartman, U.S. rates strategist at BMO Capital in New York, wrote that demand for U.S. Treasuries in the last few months had been weak. He noted that only 28% of coupon auctions have come in within or above expectations and that he had expected the same outcome for Tuesday's U.S. three-year note auction.

"The pullback in aggressive auction bidding in recent months can be attributed to heightened macroeconomic uncertainty, elevated headline risk, and volatile intraday price action," Hartman wrote.

Evercore's Shipley, however, believes this week's Treasury supply will be well-subscribed.

"Just talking to clients, they want to be in Treasuries," he said. "They know the risk out there is more elevated, so they're not really going short."