TREASURIES-Yield curve steepens after Fed says it will resume bond buying

Kate Duguid

(Recasts, new throughout; adds analyst quotes)

NEW YORK, Oct 8 (Reuters) - The U.S. Treasury yield curve steepened on Tuesday, driven by a falling two-year yield after Federal Reserve Chair Jerome Powell flagged openness to further rate cuts and said the Fed would expand its balance sheet to ensure money markets function smoothly.

Recent volatility in U.S. short-term funding markets raised concern that the Fed had allowed its balance sheet to become too small, leaving banks with an inadequate supply of reserves to manage occasional periods of high demand. Powell said the Fed would "soon announce measures to add to the supply of reserves over time."

The two-year yield, which is a proxy for investor expectations of changes in interest-rate policy, was last down 4.1 basis points to 1.424%. The fall in the two-year yield drove the yield curve steeper, last at 10.8 basis points .

Expectations of a 25 basis point interest-rate cut by the Fed at its meeting later this month rose on Tuesday to 83.9% from 74.8% a day prior, according to CME Group's FedWatch tool.

"I'm not surprised, given what happened in repo two weeks ago that the Fed needed to put something out that there was more than a short-term fix. The operations were short term and I think purchases were ultimately long-term," said Justin Lederer, Treasury analyst and trader at Cantor Fitzgerald.

He was referring to the central bank's recent intervention in money markets by offering daily repurchase agreement - or repo - operations.

Markets have been waiting for the Fed to decide what permanent policies it might put in place to avoid the sort of disruption that occurred recently, when reserve shortages pushed the target federal funds rate to the top of the range set by the central bank. That could disrupt the Fed's goals for monetary policy if it became a regular feature of financial markets.

"They definitely don't want to spin this as Quantitative Easing. It's not the same idea as what happened in 2008 - of why the Fed wants to get in. More bills, even short coupons could probably be in the mix. If you start purchasing large scale out the curve, it would really have an impact on rates, and I don't think that's what their goal was with this, said Lederer.

The United States and China will resume high-level trade talks in Washington this week.

On Tuesday, the Trump administration announced it had added some Chinese artificial intelligence companies to a trade blacklist. It then imposed visa restrictions on Chinese government officials, further ratcheting up pressure on China. (Reporting by Kate Duguid; Editing by Steve Orlofsky)