(Adds bond auction, updates prices, adds quotes)
By Daren Butler
ISTANBUL, Aug 4 (Reuters) - Turkey's benchmark bond yield dropped to a fresh historic low of 9.92 percent on Tuesday after a fresh tap of the bond attracted strong demand on expectations Turkey's aggressive interest rate-cutting cycle will continue.
The Turkish Treasury on Tuesday sold 843.5 million lira ($578 million) of the May 11, 2011 benchmark at an average yield of 10.10 percent, lower than a forecast of 10.35 percent, and giving a fresh boost to government paper in the secondary market.
Two other critical auctions were also held, with the Treasury facing its largest debt service of the year in August at 23.3 billion lira.
"The demand for the three auctions was pretty high and the yield was well below expectations," said HSBC strategist Fatih Keresteci.
Economist Simon Quijano-Evans at Cheuvreux said in a note the high level of bids from primary dealers showed: "Banks have enough liquidity and are lending it to the Treasury rather than to the private sector... and markets have woken up to the fact that the Central Bank is going to continue cutting rates."
Benign inflation data late on Monday boosting expectations of further cuts.
Turkey's consumer prices rose a less-than-expected 0.25 percent in July to leave annual price rises near a 40-year low.
The lira weakened slightly to 1.4670 against the dollar on the interbank market from a close of 1.4625. It has gained some 20 percent from its March lows.
In the first of its forex-buying auctions on Tuesday, the Central Bank bought $30 million as planned, with bids at $141 million and an average price of 1.4621 lira.
STOCK RALLY PAUSES
The ISE National 100 index traded down 0.41 percent to 44,428.11 points after jumping 4.6 percent on Monday to highs last seen in March 2008. It has gained 21 percent since end-June, helped by growing appetite for higher-yielding emerging market assets.
Tera said the blue-chip index may target resistance levels around 48,000 in the medium term, although excessive gains may prompt investors to exploit profit-taking opportunities.
Banking stocks pressured the index downwards, falling 1.27 percent after Moody's Investors Service said it placed on review for possible downgrade the local currency deposit ratings of 11 Turkish banks.
"The Moody's report is a factor. The Central Bank's rate cuts in the last eight months have lowered funding costs on Turkish lira deposits at banks, prompting a big switch from lira to foreign exchange. This has created serious open forex positions," said Sadrettin Bagci, a banking analyst at Finans Invest in Istanbul.
The total open position at Turkish banks reached $9.5 billion at the end of July from about $1 billion at the end of February, the Banking Regulation and Supervisory Agency said.
Expectations of increased profits at Turkish banks from the fall in funding costs has already been priced in and investors are selling after the banking index rallied in the past month, Bagci added.
Lender Yapi Kredi, set to release second-quarter results after the close on Tuesday, was down 0.62 percent.
(Additional reporting by Ayla Jean Yackley, Thomas Grove and Alexandra Hudson)
(Writing by Daren Butler, editing by Ron Askew)