* Fed likely to keep rates steady, signal balance sheet reduction
* Euro zone bond yields dip, stay near one-week highs
* Greece comeback bond improves sentiment towards bloc
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr
By Abhinav Ramnarayan
LONDON, July 26 (Reuters) - Euro zone government bond yields edged lower but were near one-week highs on Wednesday ahead of the U.S. Federal Reserve meeting, with rate setters expected to hint towards tighter monetary policy in the future.
The Fed is expected to keep interest rates unchanged but possibly hint that it will start winding down its massive holdings of bonds as soon as September in what would be a vote of confidence in the U.S. economy.
Such a move would add to a sense across most developed countries that extraordinary monetary stimulus is drawing to close as economies slowly recover from a debilitating set of financial and debt crises between 2008 and 2012.
“The Fed has been rather clear up to now, and I expect it to signal today that balance sheet reduction will kick off in September and a rate hike will come maybe at the end of the year,” said DZ Bank strategist Christian Lenk.
The yield on 10-year U.S. Treasuries stayed above 2.30 percent on Wednesday, having risen sharply by 8 basis points the day before, dragging European bond yields higher along with it.
Analysts at Citi said the two key points to watch for in the Fed meeting were the timing of balance sheet reduction and language discussing the recent slowdown in inflation.
“We would take as dovish any wavering in confidence that inflation will stabilise around 2 percent,” the analysts said in a note.
Euro zone bond yields were 1-2 basis points lower across the board, but only after having risen sharply on Tuesday. Germany’s 10-year government bond yield, for example, edged 1.5 basis points lower, having risen 7 basis points the day before.
At 0.55 percent, Germany’s 10-year borrowing costs are still double what they were at this stage one month ago, as investors start to price in the European Central Bank’s eventual tapering of its bond-buying programme.
Greece’s successful return to bond markets on Tuesday may improve sentiment a touch towards the euro zone as well, DZ Bank’s Lenk said.
“Greece has been more of an isolated case in the last couple of years, but investors will be a little bit relieved that we have one risk factor less in the euro zone,” he said.
The debt-laden nation successfully sold debt to private investors for the first time in three years on Tuesday, making a significant first step towards financial independence when its third international bailout ends next year.
Low-rated Southern European countries outperformed the rest of the market a touch, dropping 2-3 basis points.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
Reporting by Abhinav Ramnarayan Editing by Jeremy Gaunt.