TREASURIES-Treasuries climb in safety bid as stocks plunge

* Safety bids propel Treasuries higher as stocks plunge

* Data adds to worries the economy is stumbling

* Frozen short-term lending markets add to nervousness

By Chris Reese

NEW YORK, Oct 2 (Reuters) - U.S. Treasury debt prices climbed on Thursday in a safe-haven rally amid continued worries over frozen short-term lending markets and further evidence the economy is slowing markedly.

Wall Street stock indexes plunged, adding to the safety bid for government debt, while investors mulled whether the House of Representatives will follow the Senate and pass a $700 billion financial rescue package. While many expect the bill will be approved, they questioned whether it will help keep the economy from tumbling into recession.

Data on Thursday showing falling U.S. factory orders and rising unemployment claims only added to evidence this week that the economy is indeed struggling, and more bad news was expected on Friday when the government releases non-farm payrolls data for September.

"Bonds are higher with lower equities, and expectations are that (the bailout plan) is going to get passed but the focus is shifting from the plan fixing all the problems, to the economy having fundamental weakness that is not going away," said Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co in Seattle.

As the Dow Jones industrial average .DJI dropped more than 3.2 percent on Thursday, benchmark 10-year notes US10YT=RR traded 27/32 higher in price for a yield of 3.64 percent from 3.74 percent late on Wednesday while 2-year notes US2YT=RR gained 12/32 for a yield 1.63 percent from 1.82 percent.

Treasuries added to the session's gains after U.S. weekly initial jobless claims came in higher than expected, underscoring the deterioration of the labor market on the eve of the Labor Department's widely-watched monthly payrolls report.

Adding to the somber economic outlook, another report showed U.S. factory orders dropped 4 percent in August. For details, see [ID:nN02264937]

The report "does seem consistent with a pretty significant deterioration in economic activity in the third quarter," said Jim DeMasi, chief fixed-income strategist with Stifel Nicolaus & Co Inc in Baltimore, adding "this trend does not bode well. We could see a couple of quarters of negative GDP."

Already this week, data has shown weakness in the manufacturing sector and accelerating home price declines.

Extreme dislocations in interbank lending markets drove much of the flow into Treasuries. Banks are becoming almost exclusively dependent on central banks to provide short-term funding -- a situation that is driving investors into safe-haven assets.

As market participants worried that the unrelenting global lending crunch could push the United States and other major economies into a deep recession, investors boosted expectations of a large Federal Reserve rate cut later this month.

Short-term interest rate futures on Thursday fully priced in the perceived chance of a 50-basis-point cut in the fed funds target rate by the late October policy meeting, from a perceived chance of about 34 percent late on Wednesday.

Five-year Treasury notes US5YT=RR traded 26/32 higher in price for a yield of 2.69 percent from 2.87 percent late on Wednesday, while the 30-year bond US30YT=RR traded a full point higher for a yield of 4.17 percent from 4.22 percent. (Additional reporting by Richard Leong and John Parry; editing by Gary Crosse)