Yields drop as Fed surprises by maintaining purchases

U.S. Treasurys

U.S. Treasurys yields dropped on Wednesday to their lowest in over a month after the Federal Reserve said it would maintain its bond purchases at $85 billion a month, surprising investors who had expected it would reduce the size of its buying program.

Citing strains in the economy from tight fiscal policy and higher mortgage rates, the Fed decided against the tapering of asset purchases that investors had all but priced into stock and bond markets.

The statement caused a dramatic turnaround in Treasurys prices, which had weakened heading into the announcement.

"Obviously this was very surprising. There is no question that we were being set up for Fed tapering," said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

(Read more: Who let the dovesout? Stocks soar on taper news)

The Fed caught investors off guard. Many had been pulling out of bond funds on expectations of higher yields, while others have hedged bonds, mortgages and other holdings vulnerable to a rate spike as the Fed begins the long road of withdrawing its stimulus.

"People are completely underinvested," said Tom Tucci, head of Treasurys trading at CIBC in New York.

"It's the worst of all worlds in the sense that you just had a major liquidation and massive redemptions in bond funds, and now you have this huge rally and the Fed completely surprising people by not beginning this process," he said.

Benchmark 10-year notes were last up 1-12/32 in price to yield 2.69 percent, down from 2.86 percent before the statement and the lowest since Aug. 13.

notes gained 28/32 in price to yield 1.43 percent, down from 1.63 percent before the statement.

Thirty-year bonds rose 1-17/32 in price to yield 3.75 percent, down from 3.84 percent before the statement.

Bernanke: No calendar to taper asset purchases
Bernanke: No calendar to taper asset purchases

Weakening economic indicators in recent weeks had reduced expectations over the size of any potential pullback in bond purchases, though most expected that the Fed would make at least a small cut.

Some analysts and investors interpreted Wednesday's statement as an indicator that the Fed is also nervous over the effect of rising bond yields on the recovering housing market.

"It's pretty clear that the Fed feels that higher interest rates along with fiscal policy constraints are having a negative impact on the economy so they want to lower real yields and they sent that signal to the markets," said Michael Materasso, senior vice president and co-chair of the Franklin Templeton fixed income policy committee.

Ten-year note yields have surged from 1.60 percent at the beginning of May, when investors first became nervous that the Fed would begin paring back its bond purchase program.

The Fed will buy between $2.75 billion and $3.50 billion in notes due 2020 to 2023 on Thursday as part of its buybacks.

The failure of the market to correctly read the Fed's intentions meanwhile may make the market more volatile as investors try to gauge Fed moves in the future, with many seeing the U.S. central bank as failing to communicate effectively.

"We are going to see more volatility as the market prices in a more unpredictable Fed. There were some quite strong shorts going into the meeting," said David Keeble, global head of interest rates strategy at Credit Agricole Corporate & Investment Bank in New York.