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TREASURIES-U.S. manufacturing shrinks, 10-year yield hits three-year low

Kate Duguid

(New throughout, adds analyst quotes)

NEW YORK, Sept 3 (Reuters) - U.S. Treasury yields fell on Tuesday, with the benchmark 10-year yield hitting its lowest since July 2016, after manufacturing data showed the U.S. factory sector contracted for the first time since 2016 amid worries about a weakening global economy and trade tensions between China and the United States.

The Institute for Supply Management (ISM) said its index of national factory activity decreased in August to 49.1, the lowest since January 2016. A reading below 50 indicates contraction in the manufacturing sector, which accounts for about 12% of the U.S. economy. Last month marked the first time since August 2016 that the index broke below the 50 threshold.

"Once we go below 50, it tells you manufacturing is starting to contract," said Don Ellenberger, head of multi-sector strategies at Federal Investors in Pittsburgh.

Concerns about the economy, which is in its longest expansion ever, were also exacerbated by other data on Tuesday showing construction spending barely rising in July. The economy's waning fortunes have been blamed on the White House's year-long trade war with China.

President Donald Trump said on Tuesday trade talks with China were going well, but he warned that he would be "tougher" in negotiations if the discussions dragged on past the 2020 U.S. election and he won a second term.

Across maturities, yields fell. The 10-year yield fell as low as 1.4290% and was last down 3.2 basis points to 1.4741%. The two-year yield was 4 basis points lower to 1.4660%. The fall was greater in shorter-dated maturities, enough to steepen the yield curve out of inversion. The spread between two- and 10-year yields was last at 0.50 basis points.

The ISM report was "yet another piece of data showing a weaker manufacturing sector. That's the story. To the extent that manufacturing remains weak, that increases the potential chance for a recession down the road. That means lower yields and lower inflation expectations," said Michael Pond, head of global inflation-linked research at Barclays.

U.S. President Donald Trump said on Tuesday that trade talks between the United States and China were going well, but warned he would be "tougher" in negotiations if the discussions drag on until his second term.

"There are signs that point to a weaker manufacturing sector because of uncertainty due to the trade war and as long as the trade war continue, it will be hard for manufacturers to have confidence to start investing," said Pond. (Reporting by Kate Duguid Editing by Bernadette Baum and Nick Zieminski)