UPDATE 2-U.S. 30-year bond auction gets dismal reception

* Demand weak at 30-year bond auction

* Stocks, bonds fall after auction

* Rising yields risk higher rates throughout economy (Recasts, adds quotes)

By Burton Frierson

NEW YORK, May 7 (Reuters) - A U.S. government auction of 30-year bonds met a dismal reception on Thursday, driving down bond and stock prices and raising fears the United States may face difficulty financing spending to stimulate the economy.

The $14 billion auction met below-average demand from investors, who forced the government to pay a higher yield. An extended trend of rising yields could force up longer-term interest rates throughout the economy.

It was the first 30-year auction since the government said last week it would move to monthly sales of long bonds, which some analysts say are harder to sell than other maturities.

"It was a horrible auction," said Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co in Seattle.

"It just does not bode well for interest rates. It's ugly, it's very, very ugly," Hurley added.

Long bonds tumbled after the auction <US30YT=RR>. They were last trading down 2-15/32 in price on the day, pushing the yield up to 4.26 percent from 4.10 percent late on Wednesday.

Stocks also fell in the wake of the auction as investors worried about the government's ability to finance its huge deficits.

"We have been fearful of growing risk of something approaching a failed auction or at least a really sloppy auction with the increasing amount of supply that is out there," said John Ryding, chief economist at RDQ Economics in New York.

"We had a miserable one today," Ryding said.

Ryding said he thought the government would be able to finance its borrowing but might have to pay dearly to do so.

"The government can finance it. The question is at what yields," Ryding said. "Yields are fundamentally too low."

Previously, 30-year bonds were scheduled to be auctioned eight times per year.

TALE OF THE TAIL

Demand at Thursday's sale was somewhat low based on historical comparisons, with the bid-to-cover ratio coming in at 2.14 versus its average of 2.18.

Worse yet, the high yield at the auction was about 10 basis points above market expectations, meaning the Treasury had to offer a much bigger yield to attract buyers.

Such a big differential, or tail, is a sign of poor demand.

"It all depends on whether long-term investors show up, and they didn't show up," said Tom di Galoma, head of fixed-income rates trading at Guggenheim Capital Markets LLC in New York.

"This illustrates that government debt issuance has its limitations."

Indeed, the government bond market is also being swamped with new supply this year.

Last month, the Treasury forecast net new issuance of $2 trillion for fiscal-year 2009, which ends Sept. 30, up from $700 billion in net issuance in fiscal 2008.

The auction came a day ahead of a monthly employment report, which could show less labor market weakness than in recent months.

A sharp slowdown in the pace of the job cuts that are plaguing the recession-bound economy could convince investors that the economy is bottoming out and preparing for recovery.

Generally, this should favor riskier assets such as stocks, despite Thursday's equities reaction, as well as corporate bonds. Better economic conditions would be expected to weigh on prices for safe-haven investments such as Treasuries.

Indeed, some say the silver lining of rising yields is that it can be associated with an improving economy.

Said Ryding, at RDQ Economics: "I think in many ways it's as much a recovery signal as anything else." (Additional Reporting by John Parry; Editing by James Dalgleish)

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