-->(Bloomberg) -- U.S. Treasury prices tumbled in New York after the government sold $24 billion of three-year notes and an industry report showed service industries, the biggest part of the economy, expanded more than expected in July.

Traders drove the yield on the current three-year note up 21 basis points after the auction, the biggest increase since the Treasury reintroduced the securities in May after a five-year hiatus. Today's sale, part of this week's record $60 billion auction, comes after a rout in July drove benchmark 10-year Treasury yields to their biggest monthly rise since 1984.

``The market is in a state of chaos, and people are in no hurry to show up at a government auction,'' said Gregg Cohen, a trader in New York at CIBC World Markets Corp., one of 22 primary dealer firms that deal directly with the Federal Reserve and are required to bid in Treasury auctions. Demand for the new three- year note was ``pretty pathetic,'' he said.

The 2 percent note due in 2006 lost more than 1/2 to 99 5/32, driving its yield to 2.32 percent. A basis point is 0.01 percentage point.

The benchmark 3 5/8 percent note due May 2013 lost about 1 1/4, or $12.50 per $1,000 face amount, to 93 15/32 at 3 p.m., according to Zions Bank. Its yield rose 18 basis points to 4.45 percent. An investor who bought $10 million of 10-year notes on June 16, when yields touched 3.07 percent, would have lost more than $1 million if the notes were sold today.

Tax cuts and increased military spending have boosted the government's borrowing needs at a time when the economy is gaining strength. The Treasury is slated to sell $18 billion of five-year notes tomorrow and the same amount of 10-year notes Thursday. The White House projects the deficit will reach $455 billion in the year ending Sept. 30.

`Tentative' Investors

The new three-year notes were sold at a yield of 2.422 percent, about 3 basis points higher than their pre-auction levels, a sign of weak demand. Dealers are required to submit their bids by 1 p.m.

Investors were ``a little tentative'' after recent price declines, said Robert Lunder, head of government bond trading at Bear Stearns & Co., another primary dealer. There were $1.32 of bids for every $1 sold, compared with $1.96 in the previous three- year note auction in May.

Treasuries fell earlier in the day after the Institute for Supply Management's index of non-manufacturing businesses rose more than many analysts expected, climbing to 65.1 in July from 60.6 in the previous month, a sign that the largest part of the economy is gaining strength. Economists surveyed by Bloomberg News had expected the index to register 58.

Recovery

``It's negative for the bond market because it's going to get more and more people focused on the potential for a sustained recovery,'' said Robert Podorefsky, an interest-rate strategist at FleetBoston Financial Corp. in Boston. ``It's another indication people's expectations are a little too low.''

Demand for bonds may increase in coming days, with some investors saying that yields have risen too much in an environment where the economy is growing at half the 3.3 percent average of the past 50 years. In July, 10-year Treasury yields rose 90 basis points after reaching a 45-year low of 3.07 percent in mid-June.

``People have been sufficiently concerned about these Treasury auctions,'' using them as an excuse to stay away from Treasuries even though they are ``really, really cheap,'' said Ben Martens, an interest-rate strategist at Lehman Brothers Inc. in New York, another primary dealer. ``A major excuse not to buy will be removed as we get through the auctions, especially if they go well.''
Last Updated: August 5, 2003 15:13 EDT