LONDON, Sept 15 (Reuters) - U.S. Treasuries surged on Monday with futures on track to make their biggest one-day gain since the U.S. stock market crash of 1987 as news that Lehman Brothers had filed for bankruptcy triggered a wave of panic buying in safe-haven government bonds.

Treasuries futures jumped more than two full points to 118-7/32 to their highest since mid-April, while two-year yields dropped 40 basis points on speculation the latest Wall Street failures may prompt an emergency cut in U.S. interest rates.

After an unsuccessful last-ditch attempt to find a buyer, Lehman filed for bankruptcy protection on Sunday, while fellow failing institution Merrill Lynch agreed to be taken over by Bank of America, and the world's largest insurer American International Group appealed to the Federal Reserve for a cash lifeline [nN14440361].

Coming only a week after the U.S. Treasury took control of a pair of the nation's mammoth mortgage agencies, analysts said that the view that the government had not rescued Lehman had underlined deep-set problems in the financial sector, freezing up risk demand.

U.S. stock futures pointed to the three major U.S. indices opening 3-4 percent lower.

"Safe-haven flows are all the rage this morning given the damage at the weekend," said Philip Shaw, chief economist at Investec.

"We're in a period of uncertainty, and to a certain extent there is some panic buying."

T-note futures jumped more than 2 points to a session high of 118-16/32. The last time a futures contract posted such a daily surge was Oct. 19, 1987, famously known as Black Monday, when the U.S. stock market crashed.

By 1011 GMT, the December contract was at 118.

The price of two-year notes also jumped, sending their yields down as low as 1.787 percent, down more than 40 basis points on the day and its lowest since mid-April. It later pulled back to 1.839 percent.

The 10-year note prices also rose, pushing their yields down as much as 25 basis points to 3.465 percent, a five-month low, and steepening the 2s-10s curve.

POSSIBLE FED CUT?

The move put the spread between two- and 10-year yields at around 165 basis points, expanding sharply from late last week to hit its widest point since mid-April.

The five-year yield also hit a five-month low, falling as far as 2.559 percent, down nearly 40 basis points from late last week.

Fed funds futures showed the market pricing in an 88 percent chance of a 25 basis point Fed rate cut from 2 percent at or before its monthly policy gathering on Tuesday.

A cut by its October policy meeting is now fully discounted.

Evidence of the flight-to-quality move was also seen in swap spreads, with the two-year swap spread yawning to around 104 basis points on Monday from 94 basis points late last week, its widest point in a month and approaching its widest since Bear Stearns was taken over in a Fed-orchestrated buyout.

Investors reeled after the news of the final nail in the coffin of Lehman, once the nation's fourth-largest bank, which once again hit home the reality that the U.S. economy continues to suffer from the year-old credit crunch and that the aftermath may drag out much longer than initially expected.

This may spell more bad news for the U.S. economy, prompting market participants to acknowledge the possibility that the Fed may restart the aggressive rate-cutting cycle that many thought had ended in April.

Given the fresh focus on weakness in the U.S. economy, analysts awaited data from the manufacturing sector due later in the day, adding that weak readings in the New York Fed Empire State survey and a reading of nationwide output could offer a further boost to the bond market.

"The Fed could cut again as now priced, but easing is more likely to come in response to rising unemployment and falling inflation," Goldman Sachs strategists said in a note on Monday.

In light of the news from Lehman, Merrill and AIG, the Fed on Sunday announced a series of steps to calm markets, including its acceptance for the first time ever equities as collateral for emergency loans under its Primary Dealer Credit Facility.

(Reporting by Naomi Tajitsu; Editing by Ron Askew) Keywords: MARKETS BONDS TREASURIES

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