Bonds rally as stocks sink on bank worries

NEW YORK (Reuters) - The U.S. Treasury debt market rallied on Monday, as investors flocked into bonds from stocks amid fresh worries about the banking sector and after a credit ratings agency downgraded several U.S. investment banks.

Credit ratings agency Standard & Poor's cut the credit ratings of Lehman Brothers LEH.N, Merrill Lynch MER.N and Morgan Stanley (MS.N). S&P said outlooks on large U.S. financial institutions are "predominantly negative" on prospects of more write-offs.

U.K. mortgage lender Bradford & Bingley BB.L was also downgraded by S&P and Fitch Ratings after it earlier announced a slide in profits and restructured a rescue plan. Moreover, Wachovia Corp WB.N, the No. 4 U.S. bank, ousted its chief executive in the wake of growing legal woes and loan losses.

The dismal news punished European and U.S. shares and renewed concerns about bank troubles and their drag on the global economy.

"The worst of the credit market is over, but there are still a lot of problems," said T.J. Marta, fixed income strategist at RBC Capital Markets in New York.

The benchmark 10-year Treasury note's price was up 27/32 at 99-9/32. Its yield, which moves inversely with price, hit 3.96 percent, its lowest in three sessions and down from 4.07 percent late Friday.

The two-year note was up 10/32 in price for a yield of 2.49 percent, down 16 basis points from late on Friday.

All three major U.S. stock indexes were down by as much as 1.8 percent. .N

ISM HURTS STOCKS

In an unusual twist, a stronger-than-expected report on U.S. manufacturing ended up hurting stocks and boosting bonds.

Bond gains were briefly pared after a surprise increase in the Institute for Supply Management's barometer on factory activities. The latest reading also reinforced the notion that it is highly unlikely the Federal Reserve will cut interest rates later this month.

Treasuries quickly resumed their earlier ascent, as the sell-off in stocks intensified with investors focusing on ISM's inflation gauge, which hit a three-year high in May.

"The stock market is dominating the price action in Treasuries," said James Caron, head of global rates research with Morgan Stanley in New York.

While rising inflation hurts bonds in the long term, analysts said current Treasury yields have factored in the price pressures suggested in the latest ISM report.

The Treasury market suffered back-to-back losing months in April and May, due largely to inflation fears stemming from surging oil and food prices had pushed yields to their highest levels this year.

In contrast to the ISM data, the government's core inflation readings suggest price pressures have remained tame and oil prices have subsided from their record highs. U.S. crude futures on Monday however recovered from an earlier drop, rising than $1 at $128.75 a barrel.

In other trading, five-year notes were up 26/32 in price for a 3.26 percent yield, down from 3.44 percent late Friday, while 30-year bonds were up 29/32 for a 4.66 percent yield, down from 4.72 percent.

(Editing by Gary Crosse)