* Retail sales data to offer latest clue on U.S. economy * Fed buys $1.496 billion bonds due 2036-2043 * U.S. budget gap at $97.6 billion in July, a tad above forecast By Karen Brettell and Richard Leong NEW YORK, Aug 12 (Reuters) - U.S. Treasury debt prices ended lower on Monday on light summer volume, with bond yields staying in a tight range ahead of Tuesday's release of the government's report on retail sales. Traders have been scouring for signs of a strengthening recovery, with most expecting the Federal Reserve will start reducing its $85 billion monthly bond purchases in September if data shows the economy is gaining traction. "With people expecting the Fed to buy less bonds, you are getting a weakening in both bonds and stocks," said Justin Hoogendoorn, fixed income strategist at BMO Capital Markets in Chicago. In the near term, Tuesday's retail sales report will be watched for signs over the strength of consumer spending, which accounts for two-thirds of the U.S. economy. Economists polled by Reuters forecast retail sales likely grew 0.3 percent in July after a 0.4 percent increase in June. The most important data in coming weeks, however, and potentially the only one that might alter the Fed's course, will be the release of the August jobs data on Sept. 6, before the Fed's Sept. 17-18 meeting. Treasuries yields held on Monday in the middle of a range they have traded in since the beginning of July. Benchmark 10-year notes were down 7/32 in price to yield 2.605 percent, up 2.5 basis points from late on Friday. The 10-year yield has retreated from a two-year high of 2.755 percent on July 8, but up from the bottom of the recent range of 2.46 percent on July 17. The bond market tipped into negative territory after gaining earlier due to news Japan recorded weaker-than-expected 0.6 percent growth in the second quarter, with traders also preparing for the Fed's nearly daily bond purchase. The Fed on Monday bought $1.496 billion in debt due from 2036 to 2043 as part of its ongoing purchase program. Monday's Treasuries volume on Tradeweb's trading system was 70 percent of its 30-day average, according to the firm. SUPPLY REDUCTION Bond investors are also focused on further cuts in Treasury issuance as the U.S. government's borrowing needs decline on stronger tax receipts. The U.S. Treasury said on Monday the federal deficit was $98 billion in July, a tad more than forecast and above $70 billion in the same month last year. For the 2013 fiscal year so far, the budget gap has totaled $607 billion, down from the comparable period in fiscal 2012. The Treasury reduced its outstanding Treasury bills by $139 billion in April and July, the second-largest shift since 1995, according to UBS. It is likely to continue to reduce bill supply and extend some cuts to two-year and three-year coupon debt if trends persist, the bank said. Increasing demand for high-quality debt at the same time as the Treasury reduces supply has stirred worries that short-term rates markets could be disrupted if demand sends T-bill yields negative and creates liquidity problems in the repo market, which is a key source of short-term cash for Wall Street. UBS sees the markets remaining stable if the Treasury holds a stock of around $1.25 trillion in outstanding bills, which would leave it room to keep cutting from $1.55 trillion outstanding at the end of July. "There is a great amount of demand for bills, most of the large central banks are buyers of bills because they run conservative portfolios, and with new regulations and central clearing, demand for high quality collateral will continue to rise," said Boris Rjavinski, an interest rate strategist at UBS in Stamford, Connecticut. "We think the Treasury will be fairly judicious in how much they reduce the net bill supply," he added.