Sept. 4 (Bloomberg) -- Spending on U.S. construction projects unexpectedly fell in July by the most since January, indicating that the homebuilding slump continued to hold back economic growth at the start of the third quarter.

The 0.4 percent decline followed a 0.1 percent gain the prior month, the Commerce Department said today in Washington. Figures for June were previously reported as a drop.

Homebuilders are scaling back to try to trim the glut of unsold residential properties even as companies are still adding offices and factories. The downturn may steepen as lenders make it tougher and more expensive to get financing following the sell-off in credit markets in August.

``We're going to see another leg down, mostly because of the pain the big builders are taking,'' said Ken Mayland, president of ClearView Economics LLC in Pepper Pike, Ohio, who had forecast a decline. ``The full effects of the market volatility really haven't found their way into housing yet. The August declines may be even bigger.''

Economists had forecast total construction spending would stay unchanged after the 0.3 percent decline originally reported for June, according to the median of 54 forecasts in a Bloomberg News survey.

Manufacturing slowed in August as companies scaled back orders, expecting sales to weaken, a separate private report showed today. The Institute for Supply Management's factory index fell to 52.9, from 53.8 in July.

Treasury Yields

Treasuries fell, sending yields on benchmark 10-year notes up to 4.57 percent at 11 a.m. in New York, from 4.53 percent at the end of last week.

The economy expanded in the second quarter at a 4 percent annual rate, the fastest in more than a year, a Commerce Department report showed Aug. 30. Commercial construction jumped 28 percent, the most since 1981, adding to growth. Declines in residential construction subtracted 0.6 percentage point from gross domestic product, the sixth straight quarterly drop.

Private residential construction spending fell 1.4 percent in July, the 17th straight monthly decline, after a 0.6 percent drop in June, today's figures showed.

``We're looking at a pretty dismal start to the quarter,'' Ryan Reed, an economist at National City Corp. in Cleveland, said before the report. ``Growth will get absolutely no help from residential construction.''

Non-residential construction, including public projects, advanced 0.6 percent, after rising 0.6 percent in June. It was up 14 percent from July 2006.

Public Spending

Public construction increased 0.7 percent, helped by work on hospitals and schools. Private non-residential construction rose 0.4 percent.

Homebuilding will likely continue to deteriorate, economists said. Toll Brothers Inc., the largest U.S. luxury homebuilder, said Aug. 22 that its third-quarter profit fell 85 percent as the housing slump cut sales, increased cancellations and forced it to write down property.

``Traffic is pretty stinky out there,'' Chief Executive Officer Robert Toll said in a conference call with analysts.

At their Aug. 7 meeting, Federal Reserve policy makers concluded that ``the housing sector was apt to remain a drag on growth for some time,'' and its slowdown ``could well prove to be both deeper and more prolonged'' than had seemed likely earlier this year, minutes of the session released last week showed.

By Aug. 17, following turmoil in credit markets and a worldwide plunge in stocks, the Fed cut the interest rate at which it lends to banks, and officials said the risks to the economy have increased ``appreciably.''

Construction spending figures are based on expenditures over the life of a project, with about 75 percent of value accounted for in the first four months.

To contact the reporter on this story: Shobhana Chandra in Washington at schandra1@bloomberg.net

Last Updated: September 4, 2007 11:02 EDT