U.S. Government Bonds Edge Lower After Data

Prices of U.S. government bonds edged lower Tuesday after an inflation indicator rose at a faster pace than economists forecast, bolstering the case for the Federal Reserve to raise interest rates later this week.

The Fed starts its two-day policy meeting Tuesday and is scheduled to release an interest-rate statement Wednesday afternoon along with updates on economic and inflation forecasts. Investors expect the central bank to raise short-term interest rates a fourth time since the 2008 financial crisis.

The key question is whether the Fed may raise rates one more time later this year as projected in March or stand pat, which would impact investors' wagers on Treasury bonds and other markets.

In recent trading, the yield on the benchmark 10-year Treasury note was 2.220%, according to Tradeweb, compared with 2.215% Monday. Yields rise as bond prices fall.

The yield on the two-year note, highly sensitive to the Fed's rate policy outlook, was 1.367%, compared with 1.359% Monday. The yield traded near this year's high of 1.38% set on March 14, which was the highest close since June 2009.

Supply pressure also weighed down Treasury debt prices. After selling more than $100 billion new debt Monday, the Treasury is scheduled to sell $12 billion of 30-year bonds at 1 p.m. Tuesday. It will be the last Treasury note and bond offerings for the week.

Demand for Monday's three-year and 10-year auctions was solid. Robust foreign buying reflects that Treasurys continue to offer more attractive yields compared with their peers in Germany, Japan and the U.K. Yet some traders caution demand for 30-year bond is hard to predict.

Tuesday's report showed the producer-price index for final demand excluding food and energy grew 0.3% in May from the prior month. Economists had expected a 0.1% gain. From a year earlier, those core prices were up 2.1%, the strong gain since May 2012.

"The positive upward surprise on PPI gives the Fed some comfort in raising rates in an environment that has seen the economic numbers middling at best," said Larry Milstein, head of government and agency trading at R.W. Pressprich & Co.

The data was a departure from recent releases showing slowing inflation. The consumer-price index due Wednesday morning will be highly scrutinized by investors. The CPI excluding food and energy fell below the Fed's 2% target in April on an annualized base.

Some Fed officials say the deceleration was driven by transitory factors and won't last. Tuesday's PPI gave the Fed some comfort room to raise interest rates. Analysts say Fed officials are likely to give a nod to the recent slowing inflation data, but they may signal little change to their inflation outlook and wait for more data to draw a conclusion.

Inflation chips away bonds' fixed return over time and is considered a big threat to long-term Treasury bonds. Recent slowing inflation data have bolstered some investors' expectation that the Fed may be slow in tightening policy, which has boosted demand and sent yields lower. If inflation continues to slow down, say some money managers, it could force the Fed to hold off further increases during the second half of this year.

The 10-year Treasury yield peaked this year slightly above 2.6% in March. It fell to 2.147% last week, the lowest close since November.

Some investors don't subscribe to this view. They continue to expect the Fed to raise rates one more time this year following a possible hike in June. The 10-year yield is likely to rise later this year if this view pans out.

Another focus is the Fed's strategy in winding down its balance sheet that includes more than $2 trillion worth of Treasury debt. Fed officials signaled in recent months they may start the process before the end of this year, but they emphasized a slow and cautious approach to avoid spooking markets.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

June 13, 2017 10:38 ET (14:38 GMT)