* Treasury plans to sell $51 bln in T-bills next week
* Aug. 4 T-bill rate highest in T-bill sector
* GC repo rates rise to 14 bps as investors prefer cash
* Three-month dollar Libor rates highest since May
* Commercial paper market shrinks in latest week (Updates through, adds quote)
NEW YORK, July 28 (Reuters) - Worries the U.S. government could run out of money soon swept through money markets on Thursday, with rates soaring on Treasury bills due shortly after the Aug. 2 deadline to raise the debt limit.
Funding pressures also rose for private sector credits, as rates jumped in the repo market, which is used heavily by banks for short-term loans and by Wall Street to fund trades.
Investors pulled back from the commercial paper market, indicating that any funding crisis for the government will impact corporations' ability to raise cash quickly.
While by no means a panic, the rising rates across money markets showed investors were anticipating trouble if Congress fails to reach a deal to raise the debt ceiling by next week, when the government says it will run out of money.
"If we're past Aug. 2 I feel that the burner is going to be turned up pretty high on Congress to get a compromise bill going," said Thomas Simons, money market economist at Jefferies & Co in New York.
"If there is no deal then it'll be pretty clear before the auction that there are problems in the market because the yields will probably have sold off significantly in the days leading up," he said.
The Treasury, meanwhile, gave an appearance of normality, by announcing it intends to sell $51 billion on Monday in a refunding of three-month and six-month T-bills.
These bills settle on Aug. 4, two days after Treasury has said it may run out of cash.
AUG. 4 BILLS HURTING
Rates on T-bills maturing on Aug. 4, which the Treasury is expected to refinance, touched 21 basis points on Thursday, up from 12 basis points on Wednesday and from around zero as little as two weeks ago.
These T-bills now offer the highest rate in the entire Treasury bill universe. The rate has soared from where they were sold back in January as investors have been ridding them.
"I have avoided the T-bills that come due in the month of August," said Jill King, senior portfolio manager at Horizon Cash Management in Chicago, which manages about $3 billion.
Overnight borrowing rates in the repo market using Treasuries as collateral USGCRPO=PX also jumped to 14 basis points on Thursday. They had traded at around 10 basis points on Wednesday, a dramatic jump from the previous several weeks where they had traded near zero.
Further jumps in the rate could pose large risks.
"Some people are worried about haircuts going up, and that the cost of doing business in the repo market funding will be higher," said Richard Gilhooly, interest rate strategist at TD Securities in New York.
Haircuts are discounts a lender places on the value on collateral accepted. Haircuts rise with the perceived riskiness of the collateral. A Treasury security has long been considered riskless and requires no haircut.
As risks and volatility in the Treasuries market grow, the CME Group (CME.O) responded by raising margin requirements and increasing haircuts on its Treasury futures contracts.
At the end of business on Thursday, CME, the world's biggest futures exchange, will impose a 0.5 percent haircut on T-bills as collateral, up from zero. For details, see [ID:nNN1E76O0IK]
REPO RATE INCREASE COULD HURT
An increase in repo haircuts could have broad repercussions across financial markets as it would cause investors to reduce their leverage, in effect reducing the amount of cash available for investment.
Thursday's increase may already reflect leveraged investors moving out of positions, while money market fund managers have also been pulling out of the market, preferring to hold cash than take exposure to Treasuries.
"They don't want to be tied up in repo arrangements if they can't get their money back, or if there is a default," said Gilhooly.
Meanwhile, the U.S. commercial paper market shrank for a second week, dropping by $2.8 billion to $1.205 trillion outstanding in the week ended July 27, as investors reduced their appetite for short-term corporate debt due to worries about the U.S. debt ceiling, Federal Reserve data showed on Thursday.
Benchmark three-month dollar Libor rates USD3MFSR= also rose to their highest level since May, reaching 0.25395 percent, up from 0.25285 percent on Wednesday.
Without a debt deal investors will also be closely watching Treasury for guidance over how it may plan to prioritize payments as its cash holdings dwindle.
Treasury officials said on Wednesday they will lay out a plan in the next few days if it appears that Congress will miss the Aug. 2 deadline. (Additional reporting by Richard Leong; Editing by Leslie Adler)