U.S. Government Bonds Weaken Amid Thin Trading

U.S. government bonds weakened amid thin trading at the tail end of a surprisingly strong year for fixed-income.

The yield on the benchmark 10-year U.S. Treasury note rose to 2.423% from 2.412% Wednesday, snapping a two-day streak of declines. Bond prices fall as yields rise.

After three Federal Reserve rate increases, the 10-year yield remains near the 2.446% level at which it ended 2016, though the two-year yield is at 1.911%, the highest since September 2008, leaving investors split about the likely direction of yields next year.

The Fed has forecast it will raise rates three more times in 2018 and twice in 2019, as officials signal they intend to prevent inflation from gaining a foothold in the economy.

With investors increasingly confident that the Fed will meet its projections, some are looking for the gap between the yields to keep narrowing, as the two-year yield, which is more sensitive to expectations for changes in interest-rate policy, keeps rising.

The gap, known as the yield curve, has flattened to slightly more than half a percentage point from 1.25 percentage points at the start of the year. The flattening yield curve is seen by some investors as a sign that economic growth may slow, as recessions are frequently foreshadowed by short-term yields rising above those for longer-term bonds.

Others expect the Republican tax overhaul package to lead to more growth and inflation, pushing 10-year yields higher, and perhaps encouraging the Fed to accelerate its expected timetable for raising rates.

"This is going to be the big debate next year," said Edward Al-Hussainy, a fixed-income analyst at Columbia Threadneedle Investments.

In the year ahead, investors will also have to contend with a new wrinkle in Fed policy, as the central bank scales back its reinvestment of the proceeds of maturing bonds in order to set its balance sheet in line with pre-financial crisis norms.

The balance sheet has grown to about $4.5 trillion as the Fed pumped money into the economy to stimulate activity and promote risk-taking by investors. The central bank will be shrinking its holdings of Treasurys by about $30 billion a month and its mortgages by $20 billion a month by the end of 2018, with those funds exiting the money supply.

With the deficit expected to grow because of the tax cuts and as the Fed buys fewer Treasurys, the government has announced plans to expand its sales of shorter-term securities to help meet its financing needs. This represents the first expansion of U.S. sales of notes and bonds since the aftermath of the financial crisis.

The Treasury conducted its final bond auction of the year Thursday with a $28 billion offering of seven-year notes. Analysts said the sale attracted enough demand that bond dealers didn't need to disturb quiet markets by selling their purchases after the auction closed.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

(END) Dow Jones Newswires

December 28, 2017 17:56 ET (22:56 GMT)