Gaping U.S. trade and budget deficits and a weak auction of government debt that pushed interest rates higher pointed to a bumpy road to recovery for the world's largest economy on Wednesday.

A Federal Reserve report noting businesses see some signs of moderation in the contraction, even though conditions were weak or deteriorated further in May, failed to ease anxiety about the economy.

Instead, financial markets found new reasons to worry that massive government spending and Fed cash infusions will lead to dangerous inflation and undercut any fledgling rebound.

A government bond auction pushed yields on the benchmark 10-year Treasury note above 4.0 percent for the first time in eight months, suggesting investors want the government to pay a premium to finance its huge deficit.

U.S. stocks ended little changed though, with the three month rally stalling on worry that rising interest rates could dampen consumer and business spending.

The risk of rising yields should not be discounted, said Joseph Brusuelas of Moody's If continued, they will reduce home mortgage refinancing and curtail corporate borrowing, both critical to an economic recovery.

Federal Reserve and U.S. Treasury Department officials have cited recent economic data and relative calm in financial markets as hopeful signs that a deep recession begun in December 2007 may be approaching its bottom.

But a sharp upswing in longer-term Treasury bond yields in recent weeks, spurred by worries over the burgeoning government budget deficit, threatens to derail any renewal of consumer spending or home buying.

The rise in bond yields has come despite the Fed's pledge to buy $300 billion in long-term Treasury securities to lower borrowing costs and stimulate economic activity.


The federal budget deficit logged a bigger-than-expected $189.7 billion in May, the U.S. Treasury reported on Wednesday. The nation's trade gap also widened to $29.2 billion in April, another report showed.

The White House last month forecast the fiscal deficit for 2009 will total $1.84 trillion, more than four times the record deficit of $455 billion in 2008.

Global worries about the sustainability of those deficits were emphasized by an announcement from Russia's central bank that it would cut the share of U.S. Treasuries in its $400 billion reserves.

Higher long-term bond yields have already driven up home mortgage interest rates and shriveled the number of home loan applications. The average 30-year fixed-rate mortgage jumped to 5.57 percent last week, well above the record low of 4.61 percent set in March.

An index of mortgage applications by the Mortgage Bankers Association registered a 7.2 percent drop to a four-month low.


The Fed said in its Beige Book summary of economic conditions that several regions indicated expectations for the economy have improved, but that they still don't expect much of an increase in economic activity through 2009.

In the past year the Fed has cut bench market short term interest rates to near zero and pumped more than $1 trillion into the financial system to revive devastated financial markets and pull the economy out of recession.

Despite aggressive Fed actions, labor markets remained weak, with wages generally flat or falling, and housing markets still soft, the Fed report said.

The description of current conditions was a bit more downbeat than we expected, said Michelle Meyer of Barclays Capital.

The Fed also said prices at all stages of production were flat or falling, with the exception of oil prices.

However, some areas reported modest signs the pace of decline was easing. Some districts saw signs that job losses may be moderating, the Fed report said.

(Reporting by Glenn Somerville and Nancy Waitz in Washington, Burton Frierson and Lynn Adler in New York, and Yelena Farbichnaya in Moscow; Editing by Kenneth Barry)