* U.S. debt ceiling stalemate keeps investors defensive
* Two-year note auction met with solid demand
* Housing data mixed, consumer mood surprisingly improves (Adds economist's quote, updates prices, changes byline)
By Chris Reese
NEW YORK, July 26 (Reuters) - U.S. Treasuries prices rose on Tuesday as U.S. stock market declines renewed the safe-haven bid for bonds despite nagging worries over a possible U.S. default that could slam the value of government debt.
Fears the government will run out of cash by Aug. 2 if lawmakers do not reach agreement in debt talks actually bolstered Treasuries as investors still looked at U.S. government debt as one of the lowest-risk investments out there.
"There was some concern that an increased probability of a default or downgrade would turn investors away, but it appears that in a perverse sense, Treasuries have become a form of insurance against their own downgrade," said Thomas Simons, money market economist with Jefferies & Co in New York.
The looming deadline to raise the debt ceiling has fueled anxiety about appetite for this week's $99 billion worth of new debt supply. Those fears remained even after the sale of $35 billion of two-year notes on Tuesday afternoon was met with relatively solid demand.
"We'll see if longer duration debt performs as well. We have our doubts unless markets get more clarity on the debt ceiling before tomorrow," said William O'Donnell, head of U.S. Treasury strategy at RBS Securities in Stamford, Connecticut.
The Treasury will sell $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.
"We have a lot of uncertainties with these auctions with what's happening in Washington. People are hesitant to take on risk," said Thomas Roth, executive director in U.S. government bond trading at Mitsubishi UFJ Securities USA in New York.
Lawmakers are trying to reach a deal to raise the $14.3 trillion U.S. debt limit and avoid a default but many on Wall Street worry that the United States could lose its top-notch credit rating even if a default is averted. For details see [ID:nN1E76P002].
The benchmark 10-year Treasury note US10YT=RR traded 12/32 higher in price on Tuesday to yield 2.96 percent, down from 3.00 percent late Monday, while the 30-year bond US30YT=RR traded 20/32 higher to yield 4.28 percent from 4.31 percent.
Europe's persistent debt problems and signs of slowing U.S. economic growth have stemmed any sustained selling in Treasuries, capping a rise on bond yields, analysts said.
"Our basic stand is that a default is remote, but with each passing day, the risk of a downgrade grows. There is not a lot people will do even if there is a downgrade. Most holders of Treasuries will stick with them whether they are (rated) double-A or triple-A," said Kathy Jones, fixed income strategist at Charles Schwab in New York, which has $1.65 trillion in client assets.
A downgrade of the United States' AAA credit rating to AA could add 60 to 70 basis points to Treasury yields over time, members of the Securities Industry and Financial Markets Association said in a conference call on Tuesday. [ID:nN1E76P151]
A small majority of economists believe the U.S. will lose its top-notch AAA credit rating from at least one major rating agency, according to a Reuters poll that also found wrangling over the debt ceiling has already damaged the economy. [ID:nN1E76P12Q]
Amid the uncertainty, investors have been cautious about making big bets on Treasury prices rising or falling.
J.P. Morgan Securities said on Tuesday its latest Treasuries investor survey showed the least number of changes in bond holdings since mid-May.
"Traders are battling interest rate risk with an economy growing slower than expected. On the other hand, you have a credit event with Treasuries. The market is struggling between those two risks," said John Herrmann, senior fixed income strategist at State Street Global Markets in Boston.
Data on Tuesday showed the U.S. housing market is still struggling, while consumer sentiment surprisingly improved despite weak job conditions and anxiety over the wrangling in Washington. [ID:nN1E76P14D] (Additional reporting by Richard Leong; Editing by James Dalgleish)