TREASURIES-Wariness about Fed policy lifts yields to 8-month highs

Fri Jan 4, 2013 1:25pm EST

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By Ellen Freilich

NEW YORK Jan 4 (Reuters) - Concern that the Federal Reserve could reduce its purchases of debt securities later in the year kept yields at eight-month highs on Friday, overshadowing a U.S. employment report that showed steady, but lackluster, job growth in December.

A stronger than expected Institute for Supply Management non-manufacturing index also weighed on Treasuries prices.

Benchmark 10-year Treasury notes were down 3/32 in afternoon trade, their yields at 1.93 percent, up from 1.92 percent late on Thursday.

Bond prices have risen and yields have fallen since the start of the year, responding to minutes from the Fed's most recent policy meeting released on Thursday and to a last-minute deal that U.S. lawmakers reached on January 1 to avoid a package of tax hikes and spending cuts that would have crimped economic growth.

The Fed minutes that disturbed the bond market portrayed Fed officials as being more concerned about the potential risks of the U.S. central bank's asset purchases on financial markets, even as they continue an open-ended stimulus program for now.

"Far more important for the bond market than the employment numbers was the reminder that just because the Fed will do QE for a long time doesn't mean they will do the same amount of QE," said UBS U.S. chief economist Maury Harris. "Whether the Fed does $85 billion a month in QE or $45 billion a month makes a big difference to the bond market."

In a surprise to Wall Street, minutes from the Fed's December policy meeting, published on Thursday, displayed a sense of caution about further increases in the central bank's $2.9 trillion balance sheet, which it expanded sharply in response to the financial crisis and recession of 2007-2009.

"Several (officials) thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet," the minutes said, referring to the narrower group of voting Fed members.

"The bond market got very concerned about QE ending in mid-2013," said Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management in Minnepolis, referring to the Fed's unconventional policy known as quantitative easing. "The market was blindsided by that."

While the bond market does not think the Fed will halt its purchases of debt securities well before the end of 2013, yields have risen as traders mull the possibility of fewer purchases.

"Why should we assume the Fed will expand their balance sheet by another trillion dollars this year?" Harris said.

When the Fed settled on $85 billion a month of purchases, policymakers were worried about the potential repercussions of going off the fiscal cliff, Harris said.

"Once you move into the springtime and the Fed sees the economy is dealing with only a modest amount of fiscal restraint, I think they will cut back on the $85 billion a month amount," he said.

In December, the Fed announced it would extend its monthly purchases of $40 billion in mortgage securities and also buy $45 billion in Treasuries each month.

A few of the voting members on the central bank's policy-setting Federal Open Market Committee thought asset buying would be warranted until about the end of 2013. A few others highlighted the need for further large-scale stimulus but did not specify an amount or time frame.

Fed officials generally agreed that the labor market outlook was not likely to improve without further nudging from the monetary authorities.

U.S. unemployment has come down steadily after hitting a peak of 10 percent in late 2009, but remains elevated at 7.8 percent, according to the report the Labor Department released on Friday.

News that the U.S. services sector in December grew at its fastest clip in 10 months - rising to 56.1 last month from 54.7 in November - boosted by a rise in new orders was also negative for Treasuries prices. A reading above 50 indicates expansion in the sector.

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