By Min Zeng

Prices of U.S. government bonds pulled back slightly Wednesday, with the two-year note's yield trading near a seven-year high, ahead of the release of the Federal Reserve's minutes for its December policy meeting.

The Fed last month raised short-term interest rates for the second time in a decade. Officials projected three rate increases this year amid signs of an improving economy and the prospect of expansive fiscal stimulus from the new U.S. administration in the new year.

The Fed's tightening policy has been one of the factors sending Treasury-bond yields climbing since the U.S. election. Investors have bet that the prospect of large fiscal spending, lower taxes and lighter regulations will lead to stronger growth and higher inflation, which could potentially prompt the Fed to raise rates at a more aggressive pace than investors expect.

Higher interest rates from the Fed tend to shrink the value of outstanding bonds. Yields on short-term debt are particularly sensitive to the central bank's policy outlook.

In recent trading, the yield on the two-year note was 1.234%, according to Tradeweb, compared with 1.199% Tuesday. Yields rise as bond prices fall. The yield closed at 1.261% on Dec 15, the highest since 2009.

The yield on the benchmark 10-year Treasury note was 2.459%, compared with 2.450% on Tuesday.

The Fed's minutes are set to be released at 2 p.m. Wednesday. The next policy meeting is scheduled for Jan. 31 and Feb. 1.

"I believe the Fed is leaning towards a tighter stance with a pro-growth President-elect on the verge of being inaugurated in less than three weeks," which would leave short-term Treasury debt vulnerable to selling pressure, said Tom di Galoma, managing director of Treasury trading at Seaport Global.

Interest-rate-derivative markets show investors expect the Fed is likely to raise rates again this summer.

Fed funds futures, a popular derivative market for investors and traders to place bets on the Fed's rate-policy outlook, showed a 70% probability of the Fed raising interest rates by the June 2017 meeting, according to CME Group. The odds for the Fed to raise rates by at least a quarter of a percentage point by the Dec 2017 meeting were 94%.

One factor to influence the Fed's tightening plan this year will be President-elect Donald Trump's economic policies.

Should Mr. Trump deliver his campaign promises and give the economy a solid boost, the Fed may need to tighten more aggressively, say analysts. This scenario is likely to put selling pressure on Treasury debt, especially short-term notes, they say.

Some analysts are skeptical over Mr. Trump's policy outcome and its effect on the broader economy. They cite headwinds such as an aging population, declining productivity and the overhang of a large amount of debt from the financial crisis that would continue to undercut the pace of the U.S. growth.

The Fed's first tightening cycle since the financial crisis has been off to a slow start, driven by uncertainty surrounding the global economy in the past years.

Officials projected four rate increases for 2016 when they raised rates for the first time since 2006 back in Dec. 2015, but the Fed turned out only one rate increase last year.

That explains why some investors and analysts are skeptical the central bank could raise rates by three times this year given its poor record.

"The risk is that the Fed tries to downplay the increases in [its rate-increase projections] by emphasizing the fact it only took a couple forecast changes to tip the scale," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.

The 10-year yield has risen by more than 1 percentage point from its low set in early July. It closed at 2.6% on Dec. 16, the highest since Sept. 2014. The yield was less than half of where it traded in 2007.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

January 04, 2017 11:05 ET (16:05 GMT)

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