Bonds steady to lower as dollar, Fed reverse rally

NEW YORK, Sep 28 (Reuters) US Treasuries traded flat to slightly lower on Friday as a combination of dollar weakness, month-end position squaring and comments from a Federal Reserve official helped to reverse an earlier rally.

Bonds spent much of Friday trading higher as investors moved from riskier assets like stocks into safe-haven bonds to shore up funds at the end of the quarter. Treasuries were also given early support by data showing waning inflationary pressure.

However, those gains were pared as investors mulled shedding U.S. assets after the dollar fell to fresh record lows against the euro and a basket of major currencies on Friday.

''That seems to be the main driver (to lower bonds) is the dollar weakness, people are getting a little concerned,'' said Matthew Moore, economic strategist at Banc of America Securities in New York.

Benchmark 10-year Treasury notes traded 2/32 lower in price for a yield of 4.58 percent, down from 4.57 percent late on Thursday. Benchmark yields, which move inversely to prices, fell to as low as 4.53 percent during a morning rally, marking their weakest since Sept. 19.

St. Louis Fed Bank President William Poole said on Friday there were ''tentative signs'' that financial markets were beginning to recover from recent turmoil, which raised some doubts that the Fed was about to embark on a full-scale campaign to cut interest rates after slashing the recommended overnight lending rate to banks by 50 basis points last week.

Poole also said it would be a mistake for the market to factor in more interest rate cuts.

''It does not sound like the Fed will ease in October,'' said Andrew Brenner, analyst at MF Global in New York.

Traders also cited month- and quarter-end position squaring for the choppy trade. When expected buyers failed to appear late in the session, some investors liquidated their holdings ahead of the weekend.

Nonetheless, it has been a banner quarter for bonds as investors have sought out lower-risk assets like government debt after a crisis in the subprime mortgage sector spread and to crimp company access to credit lines. The 2-year Treasury note yield had its biggest quarterly fall in five years.

On Friday, 2-year notes traded 1/32 lower in price for a yield of 3.97 percent from 3.95 percent late on Thursday and well below the Fed's recommended overnight lending rate of 4.75 percent.

The Commerce department said on Friday that a measure of core consumer prices, which excludes food and energy items, rose 1.8 percent on a year-over-year basis in August, which department officials said was the smallest increase since a matching 1.8 percent rise in February 2004.

That was within the Fed's presumed comfort level for inflation of 1 to 2 percent, and suggested to investors the Fed could go ahead with a further benchmark interest rate cut at its next monetary policy meeting on Oct. 30-31.

Five-year notes traded 1/32 lower in price for a yield of 4.23 percent from 4.22 percent late on Thursday, while while the 30-year bond traded 2/32 higher in price for a yield of 4.83 percent.

U.S. interest rate swaps were mixed on the day, with some widening in the short end and a touch of narrowing in the long end of the curve.

Reuters MP VP0335