* U.S. 1-month bill auction rate at highest since 2008 crisis
* Weak demand signals waning confidence in timely debt deal
* Turbulence in T-bill sector seen contained for now
By Richard Leong
NEW YORK, Oct 8 (Reuters) - The normally uneventful sale of one-month U.S. Treasury debt turned into a near-boycott on Tuesday, with investors demanding the highest yields in five years as fears intensified over a possible default if the federal debt ceiling is not increased.
The U.S. Treasury Department on Tuesday sold $30 billion of one-month bills that will pay an interest rate of 0.35 percent to investors. This was the highest one-month federal borrowing cost since October 2008 when markets worldwide were roiled by the global credit crisis.
The high yield failed to stoke demand. The total amount bid relative to the size of the offering came in at a ratio of 2.75 to 1, lowest since March 2009.
"Until you see some progress, things will likely get worse," said Eric Green, global head of rates, currency and commodity research and strategy at TD Securities in New York.
One-month T-bill auctions are typically uneventful affairs, as banks, money market funds and other cash investors buy the weekly supply with confidence because of their short maturity and the full faith and credit of the U.S. government.
That confidence is now stressed to the extreme on the likelihood the United States might skip its debt payment obligations after Oct. 17, when the federal government is expected to exhaust its $16.7 trillion statutory debt limit.
The $2.66 trillion money fund industry is avoiding its exposure to those Treasury bill issues that come due in the four weeks following next week's deadline.
This nasty turn signaled waning confidence President Barack Obama and top Republican lawmakers could agree on a pact to raise the debt limit by next week. The standoff shows few signs of being resolved soon.
In a race to raise more cash before the deadline, the Treasury will sell $35 billion in five-day debt on Wednesday.
The budget impasse in Washington has not completely drained appetite for longer-dated government debt. The Treasury sold $30 billion in three-year notes to somewhat better demand than the earlier one-month bill sale.
"It's not about the probability for the government to pay, but the political dysfunction around it," TD's Green said.
The deterioration in the debt ceiling outlook has manifested in other parts of the bond market. The one-month T-bill rate climbed above the fixing on the one-month London interbank offered rate, known as Libor, for first time in at least 12 years, according to Reuters data.
"The markets now view lending money to the U.S. for one month as riskier than lending money to a bank for one month," said Guy LeBas, chief fixed-income strategist with Janney Montgomery Scott in Philadelphia.
The rate on the one-month T-bill due Oct. 31 was last quoted at 0.295 percent after it traded as high as 0.355 percent. This compared with the one-month Libor at 0.1740 percent.
RISING T-BILL RATES CONTAINED
On Tuesday, one-month T-bill rates surpassed levels set during the first debt ceiling showdown between President Barack Obama and Republican lawmakers more than two years ago.
While interest rates on T-bill issues in October to mid-November have jumped on default worries, rates in the second half of November and beyond have stayed in the single-basis-point range.
"This event of the one-month T-bill yields rising above 1-month Libor rates represents a signpost of increased risk rather than a large market move," LeBas said.
Other short-term loan markets have remained calmed as most investors and analysts anticipated a last-minute deal between the White House and Congress to raise the debt ceiling.
In the $5 trillion repurchase agreement market, which Wall Street relies on to raise cash to fund their trades, the overnight borrowing cost was about 0.10 percent, up from 0.09 percent on Monday and 0.07 percent a week earlier.