U.S. dollar banknotes are displayed in this illustration taken, February 14, 2022.
U.S. dollar banknotes are displayed in this illustration taken, February 14, 2022. Reuters / DADO RUVIC

U.S. Treasury yields eased from earlier highs on Friday after the Federal Reserve's preferred inflation gauge rose more than expected in January, but the market's reaction was muted as uncertainty reigned due to Russia's invasion of Ukraine.

The price index for personal consumption expenditures (PCE) increased 0.6% last month, one-tenth of a percent higher than December, while over the 12 months to January the PCE index rose 6.1%, the largest rise since February 1982.

The so-called core PCE price index rose 5.2% year-on-year in January, up from 4.9% in the 12 months through December. The core's gain last month was the largest since April 1983.

Interest rates normally would trend higher on rising PCE data, but a less risk-adverse mood prevailed in markets, driving equity markets higher after selling off earlier in the week.

"These yields don't seem to overlay well with the inflation picture. And the Fed being behind, it just seems like yields should be higher to me," said David Petrosinelli, senior trader at InspereX in New York.

"Rates would be higher today if we hadn't had the invasion, that's for sure," he said.

But the outlook for a potential slowdown - or drop in the pace of inflation later this year - also may be in play.

Before the data's release, the yield on the 10-year Treasury note was 3 basis points higher at 2.002%, the first time the benchmark was above 2% since last week. The 10-year's yield was last down 0.5 basis points at 1.967%.

Steady rates at the longer-end of the yield curve suggest the market does not believe the Fed can hike interest rates very fast, said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management.

"The 10-year is essentially saying that the market doesn't think we can go as quickly as the Fed might like," he said.

"The Fed is going to have trouble pushing rates up or maybe even being forced to pause at some point. There probably is going to be a big drop-off in inflation later this year," he said.

The two-year U.S. Treasury yield, which typically moves in step with rate expectations, was up 2.8 basis points at 1.574%, but down from a 14-month peak of 1.643% on Wednesday.

A closely watched part of the yield curve measuring the gap between yields on two- and 10-year Treasuries, seen as an indicator of economic expectations, was at 39.1 basis points, in line with the highest end of day level this week.

The flattening of the yield curve indicates a slowdown or even recession lies ahead, indicating in some eyes the Fed has been too slow to tackle inflation. The U.S. central bank is expected to raise rates at its next policy-setting meeting on March 15-16.

"This is a good indicator of a not soft landing, maybe a little bit of a harder landing," Petrosinelli said.

Money markets have priced in a 26.5% probability that the Fed hikes rates by 50 basis points next month, odds that are much lower than before Russia's assault on Ukraine.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.99%.

The 10-year TIPS breakeven rate was last at 2.563%, indicating the market sees inflation averaging about that rate annually for the next decade.

The U.S. dollar 5 years forward inflation-linked swap, seen by some as a better gauge of inflation expectations due to possible distortions caused by the Fed's quantitative easing, was last at 2.438%.