TREASURIES-US yields tumble after Fed continues to flag easing, slows balance sheet runoff

NEW YORK, May 1 (Reuters) - U.S. Treasury yields pulled back on Wednesday after the Federal Reserve kept interest rates steady, as expected, but signaled that it still plans to cut interest rates at some point.

The Fed did acknowledge its disappointment over the "lack of further progress" in pushing inflation down to its 2% target. The Federal Open Market Committee "does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%," the Fed said in a unanimously approved statement that still suggested that the next move on rates will be lower.

A big surprise for the market was the larger-than-expected reduction in balance sheet runoff under the Fed's quantitative tightening program. This also helped push U.S. yields lower.

The Fed said starting June 1 it was

reducing the cap

on Treasury securities it allows to mature and not be replaced to $25 billion from its current limit of up to $60 billion per month.

The U.S. central bank, however, left the cap on for mortgage-backed securities at $35 billion per month, and it will reinvest any excess MBS principal payments into Treasuries.

"The decision to hold rates steady was no surprise, but the aggressive moderation in tapering, reducing the Fed's balance sheet, was a bit of a surprise, and modestly bullish for bonds at the margin because it means that the Fed will allow less supply of bonds to hit the market off of its balance sheet," said Michael Rosen, chief investment officer, at Angeles Investment Advisors in Santa Monica, California.

In afternoon trading, the benchmark 10-year yield dropped 9.5 basis points to 4.589%.

U.S. two-year yields slid 10.7 bps to 4.939%.

John Velis, FX and macro strategist at BNY Mellon in New York, said he viewed the Fed's statement as marginally dovish.

"I am not sure the new inserted phrase about lack of progress on inflation is enough to offset that. I am surprised the Fed kept in the comment about potential future cuts," he added.

Following the Fed statement, U.S. rate futures on Wednesday have priced in a 66.4% chance of a rate hike in November, compared with 58% late on Tuesday, according to CME's FedWatch tool. It was more or less 50% in September and about 80% in December. (Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Carolina Mandl and Laura Matthews; Editing by Kirsten Donovan and Cynthia Osterman)