US bond prices drop on caution before Fed meeting

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U.S. Treasurys prices fell on Thursday, with investors reluctant to buy bonds before a Federal Reserve meeting next week that will be scrutinized for signs over when the U.S. central bank may start paring back its bond purchase program.

Bond volatility has picked up this week and yields have increased to the high end of their recent range on speculation that the Fed may start to spell out plans to reduce buying. Most economists and traders expect that the Fed may start tapering in September.

"We think that the Fed might give some preparation for tapering later in the year," said Michael Chang, an interest rate strategist at Credit Suisse in New York.

"If they suggest they may be very aggressive we could see a selloff going much further, but if they word it in a way that leaves it open ended and that they could increase QE again if there is a deflation risk then I think the market could digest it much easier," he said.

Bonds held at lower levels after the Treasury sold $29 billion in new seven-year notes to solid investor demand, the final sale in $99 billion in new coupon-bearing supply this week. The bid-to-cover ratio for the notes was 2.54, the lowest since May 2009 but indirect bidders, which includes fund managers and some central banks, bought 48.60 percent of the notes.

"There was pretty decent participation, the dealers didn't get a large percentage of them," said Tom Tucci, head of Treasurys trading at CIBC in New York. With the supply over, the next catalyst for market moves will be the Fed's statement next Wednesday at the conclusion of its two-day meeting. It will be followed on Friday by the closely watched employment report for July.

"I think there is a defensive tone going into next week's Fed meeting and payroll number," said Tucci. "We need some more information to either generate a big rally or create the next leg down on the potential tapering of QE."

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Benchmark 10-year notes were last down 8/32 in price to yield 2.62 percent, up from 2.58 percent late on Wednesday. The yields have surged from around 1.60 percent at the beginning of May on concerns over the Fed pulling back, but they are down from a two-year high of 2.76 percent on July 8.

The Merrill Lynch MOVE index, which estimates future volatility of long-term bond yields, also increased to 80 on Wednesday, up from 73 on Monday.

The index had been falling from a high as 118 on July 5 until this week. Weakness in German government debt also added some pressure to Treasurys, as better economic data reduced the safe haven bid for the bonds. Speculation over who may replace Ben Bernanke as Fed chairman was also seen adding to volatility.

President Barack Obama has not made a decision on a nominee to replace Bernanke, who is expected to step down at the end of his term in January, a person familiar with the process said on Tuesday. Former White House economic adviser Larry Summers and Janet Yellen, the Fed's vice chair since 2010, are seen as the leading contenders.

The Fed bought $4.83 billion of Treasurys maturing between in 2017 and 2018 on Thursday as part of its ongoing purchase program. It will buy between $1.25 billion and $1.75 billion in bonds due 2036 to 2043 on Friday.

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