* Bonds rise as stocks fall on economic, bank worries
* A surprise rise in ISM factory index caps bonds’ advance
* U.S. manufacturing grows for first time in five months
* Construction spending falls less than forecast (Updates market action)
By Richard Leong
NEW YORK, July 1 (Reuters) - U.S. government debt prices rose on Tuesday, as traders favored bonds over stocks on lingering woes in the banking sector and worries about corporate profits due to record oil and a slowing economy.
A surprise increase in a key manufacturing gauge, however, cast a less gloomy light on the economy and reined in earlier gains in bonds, analysts said.
Prior to the release of the latest national manufacturing data from the Institute for Supply Management, the major U.S. stock indexes were down as much as 1 percent and Treasury yields were at their lowest since early June.
Bond appetite eased in reaction to the unexpectedly strong growth components in the June ISM report, which also showed the prices paid index rose to an almost three-decade high, fanning fears of inflation that erode bond values.
“It’s negative for bonds and pro stocks. It paints a slow growth scenario with rising inflation. That’s a tough path for the Fed to traverse,” said George Adell, fixed income strategist at Commerce Capital Markets in Jupiter, Florida.
The ISM index on national manufacturing showed the sector expanding for the first time in five months. It broke above the critical 50 threshold, rising to 50.2 in June from 49.6 in May. Analysts had forecast a decline to 48.6. [ID:nWEN6523]
Moreover, the government reported construction spending fell 0.4 percent in May, less than analysts had forecast.
The benchmark 10-year note's price US10YT=RR was up 3/32 at 99-9/32, well below its early high of 99-26/32. The yield, which moves inversely with its price, was 3.96 percent, a tad lower than 3.98 percent late on Monday.
Two-year Treasuries US2YT=RR were up 2/32 for a yield of 2.61 percent, down from 2.63 percent late Monday. The two-year yield briefly touched 2.56 percent, the lowest in more than three weeks.
The three major U.S. equity indexes were moderately lower, with the Standard & Poor's 500 .SPX down 0.2 percent.
Treasuries kicked off the month on a positive note after suffering their worst quarter in four years due to worries about rising global price pressures and about central banks raising rates to fight inflation.
But traders are paring their expectations of a Federal Reserve rate increase in August because of a recent flood of downbeat reports on economic growth and news of write-downs by European and U.S. banks.
Recent regional private and Fed data had suggested further contraction in manufacturing, which would be another factor for the Fed to keep interest rates steady.
June’s surprise improvement in the ISM national factory index, however, led traders to rethink whether the economy is dismal enough to prevent an imminent Fed rate hike.
U.S. interest rate futures suggested traders see relatively low probabilities of a Fed rate hike in August but they fully expect a rate increase in October.
While the Fed will likely keep rates steady this summer, traders are nearly certain that the European Central Bank will increase key euro zone rates by a quarter point on Thursday.
In other cash trading, the five-year note US5YT=RR was up 6/32 in price for a 3.30 percent yield, down from 3.34 percent on Monday. The 30-year bond US30YT=RR was up 3/32 for a yield of 4.52 percent, flat from late on Monday. (Editing by Leslie Adler)