* Benchmark 10-year note yields lowest since August
* Short-covering adds to buying
* Fed bought $3.152 bln notes due 2021-2023
By Ellen Freilich
NEW YORK, Oct 17 (Reuters) - U.S. Treasury yields fell to their lowest in over two months on Thursday after a deal to end the U.S. debt ceiling conflict in Congress and reopen the government encouraged investors to reinvest cash and on expectations that the Federal Reserve will not scale back its stimulus in the near term.
The government had been expected to exhaust its $16.7 trillion borrowing limit on Thursday, raising fears it would not meet benefit payments and debt obligations in coming days.
"There was money waiting to be put to work until this debt ceiling issue was resolved, so there's some cash moving off the sidelines," said Matthew Duch, portfolio manager at Calvert Investments in Bethesda, Maryland.
"Also, the impact of the government shutdown and the possible fogginess of the economic data we'll get for a while has convinced more large firms that the Federal Reserve will not reduce its bond purchases until next year," he said. "It becomes harder for the Fed to remove itself from the market."
Benchmark 10-year notes rose 21/32 in price, their yields easing to 2.59 percent, the lowest since August 12, and down from 2.67 percent late on Wednesday. Those yields have dropped from 3.00 percent before the Fed decided last month not to pare its bond purchases.
Short-covering also helped lift bond prices.
"Some people had thought the 10-year yield might rise to 3 percent, but with the rally pushing the yield down to 2.60 percent, it forced some people out of their short positions," Duch said.
Data on new jobless claims in the latest week, which showed claims declining less than economists' estimates, also supported Treasuries, as a weaker U.S. employment picture would make it less likely the Federal Reserve would scale back on its bond purchases.
A stronger-than-forecast reading on the Philadelphia Federal Reserve's October business activity index briefly caused Treasuries to shave a sliver of their gains, but prices of U.S. government debt soon resumed their upward climb.
The partial government shutdown is seen as having damped economic growth, postponing the point at which the Fed would begin trimming its $85 billion a month in bond purchases.
Most market participants had expected the Fed to announce it would trim purchases at its September meeting. Now many believe that won't happen until next year. Investors are also betting the Fed won't raise interest rates until April 2015.
John Briggs, U.S. rates strategist at RBS Securities in Stamford, Connecticut, said the door remained open for "an oversold correction" in Treasuries.
"A rally led by the belly of the curve could take 10-year yields at least to 2.45 percent and five-year yields to the 1.28 percent area in the coming month to six weeks," he said.
On Thursday, five-year note yields stood at 1.33 percent.
Briggs recommended buying the dips in the 2.75 percent to 2.80 percent region on the 10-year yield.
A "rock solid" bid for Treasuries emerged overnight with buyers in Asia and real money and hedge fund buying "of the belly and intermediates in decent size," said Thomas di Galoma, co-head of fixed income rates at ED&F Man Capital in New York. He also cited "massive buying" from London-based accounts with short-covering from the dealer and hedge fund community.
With prompt payment on short-term U.S. debt now assured, rates on October U.S. Treasury bills due Nov. 14 last traded at 0.02 percent, down 1 basis points from late Wednesday, according to Reuters data.
The overnight general collateral repo rate eased a bit after the agreement in Washington, pointing to increased liquidity in the money markets, but it remained "quite elevated," said John Canavan, fixed-income analyst at Stone & McCarthy Research Associates in Princeton, New Jersey.
The U.S. overnight repo rate, at its lowest level in a week, still stood at 0.18 percent, down about 5 basis points, according to Reuters data.
The Fed bought $3.152 billion in notes due between 2021 and 2023 on Thursday as part of its plan to stimulate the economy and reduce unemployment. It will buy between $1.25 billion and $1.75 billion in bonds due 2036 to 2043 on Friday.