* U.S. Treasury sells $32 bln two-year notes, high yield 0.323 pct * Smallest monthly two-year auction in over five years * Fed buys $5.08 billion government bonds due 2017-18 By Richard Leong and Luciana Lopez NEW YORK, Oct 28 (Reuters) - Prices for U.S. Treasuries edged slightly lower on Monday as investors made room for this week's $96 billion in longer-dated government debt supply, with yields hovering near three-month lows. The Treasury on Monday kicked off the week's supply with the sale of $32 billion in two-year notes at a high yield of 0.323 percent, with the highest bid-to-cover ratio in six months. "The auction was very well bid," said Thomas Simons, a money market economist at Jefferies & Co in New York. Monday's auction was the smallest monthly supply of this maturity since August 2008. The government began reducing the size of its two-year auctions in August as a result of lower borrowing needs and ahead of introducing two-year floating-rate debt in early 2014. The two-year auction will be followed by a $35 billion sale of five-year notes on Tuesday and a $29 billion auction of seven-year notes on Wednesday. Traders and analysts anticipated solid demand for this week's sales on views the Federal Reserve will keep buying bonds at its current pace to prop up the economy, which was weakened by this month's 16-day partial government shutdown. "The prevalent opinion of the market is the Fed is on hold with tapering until 2014," said Mike Cullinane, head of Treasuries trading at D.A. Davidson at St. Petersburg, Florida. "This week's supply should be well-received." Fed policymakers will meet on Tuesday and Wednesday. They surprised investors last month when they refrained from reducing their $85 billion of monthly purchases of Treasuries and mortgage-backed securities, known as QE3. The decision spurred a bond market rally, sending the 10-year yield down some 50 basis points from a 25-month high of 3 percent. The Fed on Monday bought $5.08 billion of Treasuries maturing October 2017 to June 2018 as its latest QE3 purchase. With the Fed likely to assure investors that the current QE3 purchases will stay in place in coming months, traders and analysts said benchmark yields will likely bounce within a tight range, at least until the next non-farm payrolls report, due on Nov. 8. "This lends itself to a rangebound market," said Cullinane, who expects the 10-year yield to trade 2.45 percent to 2.65 percent in the near term. The government has released economic data that were delayed due to the shutdown after President Barack Obama and Congress reached a last-minute deal on Oct. 16 to temporarily fund federal spending and raise the debt ceiling through early 2014. U.S. factory output grew 0.6 percent in September, its largest monthly increase since February, the Fed reported on Monday. On the open market, 10-year Treasury notes were trading 2/32 lower in price to yield 2.509 percent from 2.503 percent on Friday. The 10-year yield touched a three-month low of 2.471 percent last week after disappointing September jobs figures.