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us-treasury_400NEW YORK: US Treasuries fell and yields rose on Tuesday on the view that the inflation concerns of some Federal Reserve policymakers could cause the central bank to tighten monetary conditions before year-end.

Fissures among Fed policymakers have lately grown more distinct with some so-called inflation hawks sounding alarmed about higher fuel and food prices and others emphasizing that the Fed is far from achieving its dual mandate, particularly its requirement to promote full employment.

Those who ring the inflation alarms have gone so far as to suggest that the Fed need not complete its planned purchases of $600 billion in US Treasuries, a phase of monetary stimulus scheduled to be done by the end of June.

Others, like New York Fed Bank President William Dudley, one of the Fed's most influential policy makers, believe there is no reason for the Fed to reverse a policy designed to avoid deflation and spur employment.

Minutes of the Fed's most recent policy meeting on March 15, released on Tuesday, highlighted this debate, though policymakers appeared ready to complete the rest of the $600 billion in Treasury purchases committed to last year.

"Traders are getting the feeling that more members of the (Federal Open Market) Committee are coming around to the inflation story and possible tightening as a remedy," said Kevin Giddis, executive managing director at Morgan Keegan.

This matters when investors are so focused on the Fed.

"We hang onto every word, period, and comma that comes out of the Fed these days," said Jim Sarni, managing principal at Los Angeles-based Payden & Rygel with approximately $60 billion in fixed income assets. "How the Fed articulates its message will be as important as what they actually do."

"Discomfort with the Fed on a variety of levels" was the dominant trait of Tuesday's trading session, said Ward McCarthy, chief financial economist and managing director in the fixed income division at Jefferies & Co in New York.

"There are concerns about the Fed's hawks and that ECB and BOE rate hikes will cause the Fed to move earlier toward the exit," he said, referring to the eventual unwinding of accommodative monetary policy.

Hedge fund advisor Medley Global Advisors said the European Central Bank was ready to raise rates at Thursday's meeting and leave room to tighten policy further, a source told Reuters.

"The debate is all about knowing when to declare victory in the battle against deflation," McCarthy said. "If the Fed declares victory too early, deflation risks could again increase. If they declare victory against deflation too late, they fall behind the inflation curve."

Bond prices fell even though an index showed the US economy's vast services sector slowed last month, restrained in part by supply disruptions caused by Japan's earthquake.

COLLATERAL SHORTAGE

The possibility that the Fed might address a front-end collateral shortage by doing reverse repos gave the market another element of uncertainty to contemplate, McCarthy said.

New FDIC fee assessment base rules implemented on April 1 left overnight funding markets with a collateral shortage that caused the front end of the curve to suffer from various dislocations, he said.

That led to speculation about possible steps the Fed might, or might not, take to address the situation, McCarthy said.

If the Fed put more collateral in the market to address the shortage, that could send "a very confusing signal to the market regarding monetary policy when there is already abundant confusion, uncertainty and nervousness" about policy, he said.

However, the collateral shortage could resolve without the Fed taking action, McCarthy said.

Japanese banks and other businesses that need funding over March 31 (Japan's fiscal year-end) commonly fund themselves well in advance, locking up collateral over March 31 and into the first week of April, he explained.

"As the year-end funding comes off, collateral comes back into the market," he said. "In that case, the collateral shortage will ease along with the Fed's need to address it."

Two-year Treasury notes fell 4/32 in price, their yields rising to 0.83 percent from 0.77 percent Monday.

Treasuries erased early gains on Tuesday morning after PIMCO Chief Executive Bill Gross said on CNBC that Treasuries are unattractive at current Reuters

Benchmark 10-year notes fell 16/32, their yields rising to 3.49 percent from 3.43 percent late Monday.

Copyright Reuters, 2011

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