TREASURIES-Prices down as investors mull end of rate cuts

(Updates prices, adds comments, changes byline)

By Ellen Freilich

NEW YORK, April 17 (Reuters) - U.S. Treasury debt prices fell on Thursday despite a dismal factory activity report amid signs that bond investors expect that the Federal Reserve may not cut interest rates much further.

Yields, which move inversely to their prices, rose as market participants pared back expectations for rate cuts.

Treasury prices earlier rose -- but only fleetingly -- on news that the Philadelphia Federal Reserve's business conditions index for April fell to its lowest reading since February 2001.

"The market appreciates that we're in a recession now, but thinks that the Fed has already frontloaded a lot of the rate cuts that are needed to offset weaker growth," said Zach Pandl, economist at Lehman Brothers in New York.

One sign of this is that U.S. interest rate futures now point to a Fed rate cut of 25 basis points at the Fed's next policy meeting on April 29-30, while the odds of a deeper 50-basis-point rate cut has been slashed to just 18 percent.

The Fed has cut its benchmark U.S. overnight fed funds rate by three percentage points since September to 2.25 percent.

Two-year Treasury note yields US2YT=RR, which respond closely to prospects for Fed rate moves, climbed to 2.10 percent from 1.99 percent late Wednesday. The price of the two-year note, which moves inversely to its yield, fell 7/32.

Benchmark 10-year Treasury notes slipped 2/32 for a yield of 3.72 percent US10YT=RR, from 3.71 percent Wednesday.

DREARY MANUFACTURING SHRUGGED OFF

The Philadelphia Federal Reserve Bank said its business activity index shrank to minus 24.9, much worse than expected and the lowest since February 2001, from minus 17.4 in March. The last U.S. recession lasted from March to November 2001.

Yet the broad "expectations" indexes in the Philadelphia Fed report moved into positive territory.

"It looks like most of the broad six-month indicators hit their bottom in February and we've seen some inching up since then," said Michael Trebing, an analyst with the Philadelphia Federal Reserve Bank.

Analysts also said that other manufacturing indicators were not looking as troubled as the Philadelphia index.

"The New York Empire State manufacturing index we got on Tuesday was reasonably good and the industrial production number we got yesterday was sluggish, but much better than what the Philadelphia Fed index implied," said Michael Moran, chief economist at Daiwa Securities America in New York.

Another key economic forecasting gauge inched up in March, after dropping five months in a row. The Conference Board's Leading Economic Indicators index rose 0.1 percent in March, after a 0.3 percent decline in February.

A weekly report on the U.S. labor market indicated job conditions are worsening, though the latest week's rise in new jobless claims was smaller than forecast.

Many now suspect that the U.S. central bank might pause in its seven-month rate easing cycle -- after cutting rates again at the end of this month -- so as not to fuel inflation.

Comments from some Fed officials appeared to encourage that view. Speaking in Chicago, Dallas Fed Bank President Richard Fisher said the Fed needed to provide a "bridge" for the financial system with liquidity measures, rather than simply cutting interest rates and risking higher inflation.

In Charlotte, Richmond Fed President Jeffrey Lacker said that inflation was "too high," and might not abate as hoped.

A report earlier this week showed U.S. headline producer prices running at 6.9 percent, one of the fastest rates since the early 1980s. Surging food and energy costs were behind this trend. Crude oil prices CLc1 have surged this week to record highs over $115 per barrel.

An auction of Treasury securities conducted by the Federal Reserve as part of the Fed's Term Securities Lending Facility (TSLF) drew $35.1 billion in bids from primary dealers for $25 billion of Treasury securities auctioned, the Fed said. (Reporting by Ellen Freilich; Editing by Gary Crosse)