TREASURIES-Yields drop as Fed nods to impact of higher rates

(Updated at 15:30 EDT) By Karen Brettell and Herbert Lash NEW YORK, Nov 1 (Reuters) - Benchmark 10-year Treasury yields fell to two-week lows on Wednesday after the Federal Reserve held interest rates steady and nodded at the fact that the recent increase in Treasury yields has had a tightening impact on the U.S. economy. The Fed indicated it could raise rates again, acknowledging the U.S. economy's surprising strength. But it also added a reference to tighter financial conditions as one of the factors "likely to weigh on economic activity," with still uncertain effects. “They added in the second paragraph the term ‘financial conditions’ to the credit concerns that are going to ‘weigh’ on economic activity,” said Marvin Loh, senior global macro strategist at State Street in Boston. “There was kind of this overarching view that they were going to take these higher longer-term yields and use it as a reason to not hike anymore because, implicitly in their mind it equals one or two rate hikes depending on whom you ask,” he added. “Lacking a hawkish message to come out of the policy statement, the market is interpreting it dovishly.” Fed Chair Jerome Powell said that market borrowing costs would need to be sustainably higher for that to bear on future central bank monetary policy choices. Benchmark 10-year note yields fell to 4.766%, the lowest since Oct. 17. Two-year yields dropped to 4.942%, the lowest since Oct. 10. The inversion in the yield curve between two-year and 10-year notes was at minus 18 basis points, after earlier reaching minus 24 basis points, the deepest inversion since Oct. 25. Traders are now pricing in only a 19% chance of a rate increase in December, down from 29% on Tuesday, and 26% odds of an increase by January, down from 39% yesterday, according to the CME Group’s FedWatch Tool. Yields fell earlier on Wednesday after the Treasury Department said it will slow increases in the size of its longer-dated auctions, relieving some investors who had anticipated a bigger jump in supply. It comes after the U.S. government on Monday cut its borrowing estimate for the October-December quarter to $776 billion - $76 billion less than its forecast in July. A bigger-than-expected increase in borrowing needs for the third quarter, announced in late July and early August, sparked a Treasury market selloff, with longer-dated debt taking the brunt of the weakness on concerns about growing Treasury supply. This was “"definitely not a repeat of the panic after the August announcement," said Steven Zeng, U.S. rates strategist at Deutsche Bank in New York. "Most dealers expected a repeat of the increase from August, the Treasury delivered slightly less ... and the market rallied slightly on the back of that.” The bond market was also boosted after the ADP National Employment Report showed that U.S. private payrolls increased far less than expected in October. Other data on Wednesday, however, showed that U.S. job openings increased in September, pointing to persistent labor market tightness that is supporting the economy. The Atlanta Fed, meanwhile, on Wednesday cut its growth estimate for the fourth quarter to 1.2%, down from its last GDP forecast of 2.3% on Oct. 27. This week’s main economic focus will be the government’s jobs report for October on Friday, which is expected to show that employers added 180,000 jobs during the month. Average hourly earnings are expected to have increased by 0.3% in October, following a 0.2% gain in September. November 1 Wednesday 3:30PM New York / 1930 GMT Price Current Net Yield % Change (bps) Three-month bills 5.305 5.4667 -0.021 Six-month bills 5.3025 5.5394 -0.033 Two-year note 100-28/256 4.9416 -0.129 Three-year note 99-160/256 4.7618 -0.138 Five-year note 100-232/256 4.6694 -0.149 Seven-year note 100-188/256 4.7503 -0.138 10-year note 93-24/256 4.7656 -0.109 20-year bond 90-164/256 5.1333 -0.086 30-year bond 87-40/256 4.9539 -0.070 (Reporting by Herbert Lash and Karen Brettell; Additional reporting by Davide Barbuscia and Carolina Mandl in New York; Editing by Christina Fincher, Jonathan Oatis and Andrea Ricci)