TREASURIES-Bonds surge anew as factories, banks hit

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By Pedro Nicolaci da Costa

NEW YORK, Jan 17 (Reuters) - U.S. government bonds rallied on Thursday as a slump in a regional factory activity index and fresh asset writedowns on Wall Street redoubled fears the economy is on the edge of recession.

Merrill Lynch was the latest to report huge losses, which in the fourth quarter totaled around $16 billion.

This helped trigger another steep selloff in stocks, which was compounded by a sharp contraction in Mid-Atlantic factory activity, and propelled another round of big gains for bonds.

U.S. Treasury two-year notes US2YT=RRmarched 7/32 higher, pushing their yield down 11 basis points to 2.41 percent, its lowest in more than three years.

"Both the bond and equity markets are forecasting a recession," said Hank Smith, a market analyst at Haverford Investment.

Many said the Philadelphia Fed's manufacturing data was consistent with broader economic contraction. Its index plummeted to -20.9 from -1.6, a drop not seen since just before the start of the last U.S. recession back in 2001.

U.S. housing starts also took another plunge, falling to their lowest level in more than 16 years and signaling that the mortgage sector's descent was probably nowhere near over.

The U.S. economic data reaffirmed expectations for aggressive monetary easing by the Federal Reserve, reinforced by a lingering pessimism about the economy in central bank chief Ben Bernanke's testimony before Congress on Thursday.

Interest rate futures had already fully priced a half percentage point cut from the Fed later this month, and saw the chances of an even bolder 75 basis point cut as basically a coin toss

In this environment, ongoing talk that the Treasury market had been overbought has been consistently overrun but yet another spurt of buying.

U.S. benchmark ten-year notes US10YT=RR jumped over a full point, pushing their yield down to 3.62 percent, near a 4-1/2-year low.

(Reporting by Pedro Nicolaci da Costa)