* Fed hints of further rate hikes on expected inflation pickup
* U.S. leans on short-dated debt to fund growing deficit
* ADP data shows further improvement in U.S. labor market
* Global bond markets suffer worst month in over a year
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By Richard Leong
NEW YORK, Jan 31 (Reuters) - The spread between longer-dated U.S. Treasury yields and short-dated ones contracted to the slimmest in over a decade on Wednesday as the government favored selling more short-dated debt than longer-dated issues to finance the projected rise in its budget deficit.
The yield curve also flattened as the Federal Reserve bolstered the notion it would raise key borrowing costs at least three times in 2018 on an expected pickup in inflation.
"We are big advocates of the flattener trade," said Mark Lindbloom, portfolio manager at Western Asset Management Co. in Pasadena, California with $442 billion in assets.
The yield curve has further room to flatten longer term with intermittent bouts of steepening, Lindbloom said.
Month-end purchases of longer-dated Treasuries was another factor that flattened the yield curve as investors reallocated money into bonds from stocks after the S&P 500 index recorded its best month since March 2016. On the other hand, Treasuries have lost about 1.4 percent in January, marking their worst monthly performance since November 2016, according to an index compiled by Bloomberg and Barclays.
Other bond markets also sustained the steepest losses in more than a year.
Longer-dated Treasury yields initially rose on Wednesday when the government said it will increase the monthly auction size of 10-year and 30-year debt. They quickly retreated when traders focused on faster increases in two-year and three-year maturities versus the rise in longer-dated supply."They were more aggressive on the front-end than what people had expected," said Tom Simons, money market strategist at Jefferies & Co. in New York.
A Washington think tank estimated the federal budget gap would surpass $1 trillion in 2019 and may hit $2 trillion in 2027 stemming from late December's massive tax overhaul. The spread between five-year and 30-year Treasury yields shrank to near 41 basis points, a level not seen since August 2007, before finishing at 42 basis points in late trading, according to Tradeweb. Benchmark 10-year Treasury yields were little changed on the day at 2.726 percent after reaching a near four-year peak at 2.754 percent.
The five-year yield reached 2.553 percent, the highest since April 2010, while the two-year yield touched 2.165 percent, the highest since September 2008.
On the data front, ADP Research Institute said U.S. companies hired 234,000 workers in January, more than the 185,000 projected by economists polled by Reuters. The latest ADP data reinforced the view of a labor market at or near full employment which would support the Fed raising rates in March, analysts said. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ U.S. yield curve flattest in a decade Government bond returns 2017 Worst month for bond markets since late 2016 ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>(Reporting by Richard Leong; Editing by Frances Kerry and Chris Reese)
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