TREASURIES-Shorter debt falls as bailout optimism grows

* Hopes on bailout passage rein in appetite for bonds

* Investors shift out of bonds into stocks

* Weak data caps unwinding of safety trades in Treasuries

* Treasuries briefly extend losses after 5-yr note auction (Updates market action, adds quotes)

By Chris Reese

NEW YORK, Sept 25 (Reuters) - U.S. Treasury debt prices fell on Thursday as traders reversed a recent dash for safety on growing optimism that a sweeping government bank bailout would be approved by Congress.

A fresh spate of gloomy economic data, however, reinforced the view that even a massive bank rescue may not be enough to avert a recession. The data also fanned speculation that the Federal Reserve will cut interest rates by year-end, analysts said.

After two days of public hearings, Congressional leaders raised hopes that $700 billion package to rescue the ailing U.S. financial industry will pass before the weekend. This sparked traders to unwind safe-haven holdings in Treasuries and lifted stock prices.

"Stocks are drawing some bids from Treasuries," said Josh Stiles, senior bond strategist at IDEAglobal in New York.

Major U.S. stock indexes were sharply higher, with the Standard & Poor's 500 .SPX up 2.4 percent.

Benchmark 10-year Treasury notes US10YT=RR were down 10/32 in price for a yield of 3.86 percent from 3.82 percent late on Wednesday, while 2-year Treasury notes US2YT=RR were 6/32 higher for a yield of 2.15 percent from 1.97 percent.

The one-month Treasury bill or T-bill rate US1MT=RR climbed to 0.51 percent in midday trading, up a whopping 39 basis points from late Wednesday. Investors were flocking into T-bills and cash earlier this week on anxiety about the struggling financial sector and its toll on credit markets and the economy.

While traders pinned hopes on the bailout bolstering markets and the economy, the latest government data showed ongoing deterioration in various economic sectors.

The government said on Thursday that first-time filings on jobless benefits last week rose to the highest in seven years, while durable goods orders fell 4.5 percent in August, almost three times greater than what analysts polled by Reuters had forecast. New-home sales fell more steeply than expected in August to the lowest annual rate since 1991. For details see [ID:nN25327565].

Bonds briefly extended losses on Thursday afternoon after an auction of 5-year notes US5YT=RR generated lackluster demand. The bid-to-cover ratio, a gauge of demand, was 1.91, below the 2.13 average for these auctions so far this year. (Additional reporting by Richard Leong; Editing by James Dalgleish)