A New York state manufacturing gauge published on Tuesday hit its highest level since October this month, while sentiment among home builders rose more than expected, signaling continued improvement in the U.S. economy.

But analysts said the data also showed a factory rebound might run out of momentum.

At the same time, a U.S. capital flows report showing China paring its Treasuries holdings underscored analysts' worry that the recovery could be stymied by a steep rise in bond yields, making borrowing more expensive for homeowners and companies.

However, the generally stronger-than-expected economic data helped boost risk appetite and drove Wall Street stocks up more than 1 percent in afternoon trading.

The New York Federal Reserve said in a barometer of manufacturing in New York state rose in February as inventories jumped. Its Empire State general business conditions index rose to 24.91 in February, the highest level since October and up from 15.92 in January.

The U.S. manufacturing sector shows no signs of slowing down in February, said Kathy Lien, director of currency research at GFT in New York. The strong number will lead the markets to expect a similar improvement in the Philadelphia Fed index, which will be released on Thursday.

On the surface, the index appeared to reinforce the impression that industrial companies are continuing to bounce back after the long recession. Economists polled by Reuters had expected a February figure of 18.

Despite a stronger-than-expected headline reading, however, some analysts said the details of the report were somewhat more bearish.

A lot of the improvement was driven by a correction of inventories, said Anna Piretti, senior U.S. economist at BNP Paribas in New York. It's a temporary factor. What worried me more was a sharp decline in new orders.

The inventories index rose sharply, to zero from negative 17.33, its highest reading in more than a year.

But the new orders index tumbled to 8.78 in February from 20.48 in January -- a warning sign that activity could decelerate in the future.

However, the report offered some signs of improvement in the job market at factories. Employment indexes were positive for a second consecutive month, although at relatively low levels, the Fed said.

Separately, the National Association of Home Builders said U.S. home-builder sentiment rose more than expected in February as low interest rates and a sharper-than-expected drop in unemployment boosted confidence for the first time since September.

The percentage of Americans falling behind on credit card bills stabilized in January, according to data from five lenders released on Tuesday, signaling that U.S. consumer credit woes may be leveling off.

CHINA CUTS TREASURIES

But continued improvement in U.S. mortgage and other lending markets still depends on borrowing rates staying low, a factor influenced by foreign purchases of U.S. debt.

Overall, net capital inflows into the United States rose to $60.9 billion in December from an inflow of $30.9 billion the prior month. But foreigners cut purchases of long-term securities, the Treasury said on Tuesday.

China has been a net seller of some $45 billion of U.S. Treasuries over the last five months, wrote Alan Ruskin, chief international strategist with RBS Securities Inc. He added that it was a long enough period to hint strongly at a trend.

Japan overtook China as the biggest foreign holder of U.S. Treasury debt in December for the first time in more than a year.

Much of China's selling has been in short-dated Treasury bills, but China has not indicated that it will buy longer maturity U.S. government notes and bonds instead. That is the bad news for the U.S. dollar and the Treasury market, Ruskin wrote.

Analysts said this underscored the risk that waning appetite for U.S. debt among major foreign holders could spark a sell-off and send yields rising.

Over the longer term, borrowing costs may determine how anemic the U.S. economic recovery will prove.

The U.S. economy will likely grow at a pace of close to 3 percent over the next two years, slower than many private-sector economists forecast, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said on Tuesday.

Also on Tuesday, Kansas City Fed President Thomas Hoenig said the ballooning U.S. budget deficit will increase pressures on the Fed to hold interest rates low and make it harder to avoid inflation.

(Additional reporting by Emily Flitter and Steven C. Johnson and Dan Wilchins, Editing by Dan Grebler)

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