By Sam Goldfarb

U.S. government bonds pulled back modestly Wednesday as investors reacted to strong economic data before the Federal Reserve kept interest rates unchanged at the end of its two-day policy meeting.

The yield on the benchmark 10-year Treasury note settled at 2.466%, up from 2.451% Tuesday, though down from 2.492% before the Fed released its afternoon policy statement.

The yield on the two-year note, which is highly sensitive to the Fed's policy outlook, settled at 1.212%, compared with 1.204% Tuesday and 1.240% before the statement.

Yields, which rise when bond prices fall, jumped in the morning after a report on private payrolls showed that 246,000 jobs were added last month. That was well above the 164,000 expected by economists polled by The Wall Street Journal, and a possible sign that the more closely watched jobs data compiled by the Labor Department could also be robust when they are released Friday.

The private payrolls data "caught the market by surprise," said Subadra Rajappa, head of U.S. rates strategy at Société Générale SA. "The real risk going forward is the potential for the Fed to turn a little bit more hawkish sooner than the market expects."

Adding to the pressure on bonds, the Institute for Supply Management said its purchasing managers index, a gauge of U.S. factory activity, rose to 56.0 in January, its highest reading in more than two years.

A strengthening economy and tightening labor market should generally lead to faster wage growth and inflation. That in turn would chip away at the fixed returns of bonds and potentially cause the Fed to raise interest rates, which would also diminish the value of outstanding government debt.

Having just raised interest rates in December for the second time since 2006, the Fed was widely expected to stand pat this month. Its policy statement gave little indication about when it will next raise rates, prompting bonds to retrace some of their earlier declines in the absence of a stronger signal that officials were ready to take imminent action.

Greater insight into the Fed's policy outlook should come on Feb. 14, when Fed Chairwoman Janet Yellen delivers her semiannual monetary report to the Senate Banking Committee.

Fed-funds futures, a popular derivative market for investors to place bets on the Fed's rate policy, showed Wednesday afternoon a 36% probability for the Fed to raise rates at least by a quarter of a percentage point by its May meeting, according to CME Group. The odds were 38% on TuesdayWhile Fed officials have signaled that they expect to raise rates three times this year, many investors have remained skeptical, noting that the central bank only raised rates once last year after initially projecting four increases.

One wild card remains the potential for expansionary fiscal policy out of Washington. U.S. government bonds sold off sharply after the November election as investors bet that President Donald Trump and a Republican-controlled Congress would expand the budget deficit in an effort to boost economic growth.

Yields, though, have leveled off more recently given uncertainty surrounding Mr. Trump's plans and his focus on policies that enjoy less support among investors, including curbs to immigration and trade protectionism.

Write to Sam Goldfarb at sam.goldfarb@wsj.com

(END) Dow Jones Newswires

February 01, 2017 15:56 ET (20:56 GMT)

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