* Manufacturing indexes, stocks gain dent demand for bonds
* U.S. manufacturing grew at fast pace in 2-1/2 years - ISM
* Italy, Spain, Portugal debt rally hurts bid for Treasuries
* Bond market more focused on debt ceiling than shutdown
By Ellen Freilich
NEW YORK, Oct (KOSDAQ: 039200.KQ - news) 1 (Reuters) - U.S. Treasuries prices fell on Tuesday as strong manufacturing indexes, stock market gains, and a rally in peripheral European debt all dented demand for Treasuries, still seen as a safe-haven despite a partial U.S. government shutdown and impending debt ceiling battle.
U.S. manufacturing grew last month at its fastest pace in nearly 2-1/2 years. Manufacturing grew in Italy and Spain, the euro zone's third and fourth-largest economies, as it did in Germany, Europe's largest economy. U.S. stocks rose despite the U.S. government shutdown.
The debt of Italy, Portugal and Spain rallied on signs the Italian government would muster enough support in a confidence vote to ward off a new round of hotly contested elections.
The market impact from a stalemate over the U.S. federal budget that caused the first partial U.S. government shutdown in 17 years was mainly seen at the short-end of the maturity curve when a U.S. one-month bill sale got the highest rate since November.
"Globally, manufacturing survey data was relatively strong. The U.S. number beat expectations and last month's number and that created some optimism," said Jake Lowery, Treasury trader at ING U.S. Investment Management in Atlanta (BSE: ATLANTA.BO - news) .
Reports that Italy's government looked likely to survive a confidence vote helped peripheral bonds, he noted.
"That reduced demand for safe-haven assets like Treasuries and German bunds," Lowery said.
The partial shutdown of the U.S. government, which could put up to 1 million workers on unpaid leave and hurt U.S. and global growth, prompted a variety of views.
Lowery said for now, bonds were paying more attention to the debt ceiling deadline than to the government shutdown. Treasury bills maturing on Oct. 31, soon after the Oct. 17 deadline cited by the U.S. Treasury Department for raising the debt ceiling, have "cheapened significantly," he said.
If Congress agrees to a new funding bill soon, the shutdown would have relatively little impact on the world's largest economy.
But without that, markets could soon feel an information deficit as the shutdown deprives them of the fresh government data on the economy to which they are accustomed.
"People say the bond market does not move much on the monthly economic reports, but boy when we don't have them, the tone of trading - if not the volume - drops dramatically," said Chris Rupkey, managing director and chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.
"Wall Street clients move money and buy and sell securities when they change their view. Without the government economic reports, there is no reason to change your view," he said.
"A bad quarter for fixed income trading and commissions is going to get even worse in the days ahead," Rupkey said.
Rupkey said the shutdown "could last three weeks like the last time.
"They really can't start it again without resolving the debt ceiling limit problem, and (the deadline for)that, according to Treasury, is October 17," he said.
Amid the uncertainty created by the U.S. government shutdown and imminent debt ceiling battle, Wells Fargo Advantage Funds chief fixed-income strategist James Kochan said cash remained expensive relative to nominal Treasuries.
With the Federal Reserve in no hurry to raise short-term interest rates, "cash will underperform for another two years, as it has for the past four," he said.
Predictions of negative returns for bonds once the Fed starts to tighten monetary policy do not give enough weight to the role "today's exceptionally steep yield curve could play in future bond performance," Kochan said.
In six postwar periods of Fed tightening, a steep yield curve has flattened "significantly" by the end of the tightening cycle, he observed. The steep yield curve plus coupon income ive could still give investors positive returns even if bond prices decline somewhat, he said.
The Treasuries market earned 0.7 percent in total returns in September, its first monthly gain since April. The recovery last month helped lift the market's third-quarter performance into positive territory, also generating a 0.7 percent return. In turn, this reduced its year-to-date loss to 2.01 percent. The loss was tied to a sharp summer sell-off due to fears that the Federal Reserve might reduce its stimulus later this year, according to an index compiled by Barclays (LSE: BARC.L - news) .
On Tuesday, Day 1 of the U.S. government shutdown, benchmark 10-year Treasuries notes fell 8/32 in price. Their yields rose to 2.65 percent from 2.61 percent late on Monday.
The 10-year yield touched its lowest level in seven weeks on Monday, spurred by last-minute safe-haven bids before the partial government shutdown.
ONE-MONTH BILL RATE JUMPS
While reaction to the government shutdown has been muted so far, investors worry the conflict in Washington would cause a government default if lawmakers do not agree to raise the $16.7 trillion borrowing limit, expected to be reached on Oct. 17.
Investors seemed reluctant to load up on ultra short-dated U.S. debt, which might face turbulence as the debt ceiling deadline looms. At Tuesday's $35 billion sale of U.S. one-month T-bills, the Treasury paid 0.12 percent to investors, the highest rate paid on this debt maturity since November.
On the open market, the interest rate on one-month T-bills rose to 0.08 percent, up 5.5 basis points on the day and on track for its biggest single-day rise since late July 2011 in the days of the first debt ceiling showdown between President Obama and top Republican lawmakers.
For now, many traders do not expect the U.S. government to stop meeting its debt obligations, which are held in pension funds, retirement accounts and central banks worldwide.
"It's way too early to price in a technical default. That's a very long shot," said Mike Cullinane, head of Treasuries trading at D.A. Davidson in St. Petersburg, Florida.
In the derivatives market, the cost to insure against a U.S. default retreated from its highest level in more than four months. Investors would have to pay about 31,995 euros annually to insure 10 million euros worth of Treasuries against a default in five years, down from 33,217 euros on Monday's close, according to data from Markit.
Early casualties of the partial government shutdown were official economic reports. The Commerce Department said on Tuesday it postponed the release of its September reading on construction spending.
The Labor Department said last week it will not publish the closely-watched employment report, which was slated for release on Friday, if a shutdown occurs. But it will put out its weekly jobless claims report on Thursday.
As a result, investors will rely on privately produced economic indicators, which include ADP's private employment report on Wednesday.
Economists estimated each week of reduced federal services would take away 0.1 percentage point of the U.S. gross domestic product.