TREASURIES-US yields dip ahead of Fed decision, markets eye guidance on rate path

By Karen Brettell and Gertrude Chavez-Dreyfuss

NEW YORK, Dec 2 (Reuters) - U.S. Treasury yields were flat to modestly lower on Tuesday, pulling back from the previous session's highs, as markets awaited next week's Federal Reserve decision, with a rate cut largely priced in and the focus on guidance about future policy moves.

U.S. yields had been dragged higher on Monday by a surge in Japanese government bond yields, after Bank of Japan Governor Kazuo Ueda signaled that the central bank will consider the "pros and cons" of raising rates at its next policy meeting.

By Tuesday, however, the focus had shifted firmly back to the Fed.

Fed officials are in a blackout period ahead of the U.S. central bank's December 9-10 policy meeting, and are temporarily restricted from making public comments or speeches about monetary policy.

Tuesday's data calendar was light but investors are bracing for a series of releases later in the week, including U.S. services sector figures, ADP private payrolls, jobless claims and a stale personal consumption expenditures price index for September. None of these reports, however, are expected to materially influence the Fed's decision to ease for a third straight meeting.

Fed funds futures traders are now pricing in 89% odds of a cut next week, according to the CME Group's FedWatch Tool.

J.P. Morgan expects the Fed to cut rates by 25 basis points next week, followed by a similar reduction in January. That would bring the benchmark fed funds rate to 3.25%, after which policymakers are projected to pause.

"If we get this world in which we return to trend, if not above trend, growth and the labor market stabilizes, the Fed's going to unlikely move to 3%, which they have deemed neutral because there's probably no reason to get back to neutral with inflation still running above 2%," said Jay Barry, head of global rates strategy at J.P. Morgan in a press briefing on Tuesday.

"The only thing that gets the Fed to deliver more decisive cuts will be more decisive weakness in the labor market...(But) this is an economy that doesn't have a lot of vulnerabilities. Yes, we see a little bit of stress from low-end consumers, but by and large, labor income is holding up."

Earlier in the day , President Trump said he would announce his choice to succeed Jerome Powell as head of the Fed early next year. White House economic adviser Kevin Hassett, a known dove, is currently seen as the frontrunner to be the Fed chair, which increases the possibility of aggressive monetary easing at the central bank.

CONSOLIDATION AHEAD OF FED MEETING

In afternoon trading, the benchmark 10-year yield slipped 1.1 basis points (bps) to 4.085% US10YT=RR, after hitting a nearly two-week high earlier in the session. It fell 8.2 bps in November, the largest monthly fall since August.

U.S. 30-year yields were also slightly down at 4.737% US30YT=RR.

On the front end of the curve, the U.S. two-year note US2YT=RR yield, which typically moves in step with interest rate expectations for the Federal Reserve, fell 2.9 bps to 3.512%.

"The Fed has seen the biggest data that they'll see before the meeting and I think we're just looking at a period of Treasuries being range-bound and some sort of consolidation," said Will Compernolle, macro strategist at FHN Financial in Chicago.

The Treasury yield curve steepened, with the spread between U.S. two-year and 10-year yields rising to 59 bps US2US10=TWEB, the widest gap since early September, from 55.4 bps on Monday. The curve was last at 57.3 bps.

The curve showed a bull-steepening pattern, a scenario in which shorter-dated yields are falling much faster than those on long maturities, which reflects expectations that the Fed will cut soon.

Fed expectations have wavered in recent weeks between a probable rate cut and a likely hold on rates, as policymakers' views diverge. Many Fed officials have expressed concerns about stubbornly high inflation.

In other developments, the Treasury trimmed the issuance of four- and eight-week bills for a second straight week, which analysts said was widely anticipated after debt managers flagged it at the November refunding announcement. The reduction reflects expectations for mid-month corporate tax payments and other inflows, but auction sizes are projected to rise again by mid-January to accommodate anticipated fiscal outflows.

The cuts bring the four-week auction to $90 billion from $100 billion previously, and down from a record $110 billion in mid-November. The eight-week offering was reduced to $80 billion from the prior $85 billion, below its all-time peak of $95 billion in mid-November.