LONDON: US Treasuries slipped in Europe on expectations a German court would approve the euro zone's new bailout fund but underlying market sentiment was firm on speculation the Federal Reserve will announce another bond buying programme this week.
Treasuries reversed earlier gains after Germany's Constitutional Court said it would not postpone Wednesday's ruling on the legality of the European Stability Mechanism.
A negative outcome, which most legal expects see as unlikely, would threaten the European Central Bank's plans to buy the bonds of struggling euro zone states to bring down their borrowing costs.
Concerns that Spain was not moving closer to seeking aid from the region's rescue funds, a condition for the ECB bond purchases, was capping losses in Treasuries. Spanish Prime Minister Mariano Rajoy said late on Monday he would not accept a rescue that dictated spending cuts.
US 10-year T-notes were last 4/32 down in price to yield 1.67 percent, 1.4 basis points higher than in late US trade on Monday. The benchmark yield was still well within the 1.542-1.174 percent range that has prevailed over the past week.
"There's a lot of headline risk ... The German Constitutional Court says the latest objection will not delay their verdict tomorrow. Treasuries were doing well but yields have moved up just on that one headline," a trader said.
"It's going to be hard to navigate the market this week. I think the German Constitutional Court decision will be positive. They will say OK to the ESM although there might be conditions. But then there's a lot of risk events for the market. You've got a three-year auction today, 10s tomorrow and the Fed on Thursday."
OPEN QE3 TARGET?
Market expectations the Fed will announce a third round of bond purchases with new money, known as QE3, at the conclusion of its Sept. 12-13 policy meeting have increased since data on Friday that showed US jobs growth slowed sharply in August.
The chances of the Fed embarking on such monetary stimulus this week have risen to 60 percent, according to a Reuters poll of economists, up from 45 percent in a poll taken in late August.
"The impact on Treasuries partly depends on the size of the programme and much of the current talk is centred on an open target with the Fed reviewing its commitment at each meeting," said Philip Shaw, chief economist at Investec.
If the Fed were to announce QE3 this week, 10-year Treasury yields may eventually rise toward around 1.8 percent to 1.9 percent assuming that US economic conditions improve toward the year-end, said Tomoaki Shishido, rate analyst for Nomura Securities in Tokyo.
The more bond-friendly scenario would be for the US central bank to hold off on QE3, and simply extend its conditional pledge to keep interest rates low through late 2014, Shishido said, adding that he thought that was the more likely outcome from this week's Fed meeting.
"It would be harder for inflation expectations to rise," he said, adding that such an option was also unlikely to trigger a sharp rally in risky assets.
If the Fed extends the likely period of very low interest rates to the second half of 2015, 10-year yields may have scope to fall by around 10 basis points from where they are now, Shishido added.
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