Markets may turn turbulent waiting for debt deal

If you think the last few days have been tumultuous for markets, just watch as August 2 approaches.

If you think the last few days have been tumultuous for markets, just watch as August 2 approaches.

Financial markets have largely ignored the debt limit talks in the U.S. so far. They're reacting instead to concerns about debt in Europe and dismal employment numbers.

But that's bound to change as the U.S. gets closer to maxing out its self-imposed borrowing limit of $14.3 trillion on Aug. 2. Analysts and investors expect Congressional Republicans and President Barack Obama will agree to raise the country's borrowing limit and cut spending before the deadline. Many of those same people also believe the haggling will go on until the last minute.

"If they take it to the brink, it'll be a dangerous game of chicken," said Tony Crescenzi, a market strategist at bond-fund giant Pimco.

Many investors are preparing for a potential default before time runs out.

Then there's the matter of what happens after a deal is reached. The scenarios Wall Street economists have come up with for life after Aug. 2 aren't exactly rosy.

The concern, say analysts at Barclays, is the deep spending cuts that will accompany any agreement to raise the U.S. debt limit. Federal spending accounts for 8 percent of gross domestic product, a broad measure of the economy.

A debt limit agreement that includes cutting $2 trillion in spending is sure to weigh on the recovery. Goldman Sachs economists say it could shave 0.8 percentage points off economic growth next year.

So what should you expect to see in stock, bond, and currency markets as the days tick by? Preparation for disaster.

With 10-year Treasury yields at 2.90 percent on Tuesday afternoon, government borrowing rates are near their lows for the year. At current rates, traders are still treating Treasurys as one of the world's safest investments. It's no wonder. Rising unemployment and Europe's widening debt crisis have drawn investors to U.S. government bonds, sending prices higher and yields lower. Treasury yields tend to fall on dire news and rise on signs of economic strength.

But as Aug. 2 gets closer U.S. government debt prices may fall, driving up interest rates.

One trigger to watch: Short-term Treasury bills. Yields have been near historic lows — close to zero. That could change.

Standard & Poor's and Moody's Investors Service may renew warnings that they will reconsider the country's coveted AAA credit rating, says Guy LeBas, chief fixed income strategist at Janney Morgan Scott. That could happen as soon as next week. When it does, rates on short-term Treasury bills could spike because the government has to pay them off every week, making these T-bills riskier. LeBas and others don't think the debt ceiling will be lifted until the very last minute, making such a spike all the more likely.

Problems in the Treasury market could quickly spill into banks and money-market funds. That could create a short-term credit crunch as fears mount over how many bonds each bank holds. Banks are among the largest buyers of Treasurys. They also use Treasury bills to back money-market funds.

Stocks and corporate bonds, which have benefitted from rising earnings and low interest rates over the last year, will likely take a harder hit. The dollar may also sink against other currencies, Crescenzi says, as traders attempt to shield themselves from the fallout.

For the next two weeks, the parade of companies reporting second-quarter earnings will consume the stock market's attention, says John Canally, investment strategist at LPL Financial. "But if we're here on July 25 and nothing is getting done, that's when I'd say the equity markets start to pay attention," Canally says.

A sharp bond-market move could also spur a stock-market selloff that could resemble the summer of 2008. Back then, banks, energy companies, and material producers fell more than the overall market. Companies that deal in consumer staples fared the best since most people will cut spending on luxuries before paring back purchases of macaroni and bath soap.

When a deal is reached to raise the debt ceiling, expect to see markets celebrate with a "relief rally." Stocks will likely jump as the fear of a U.S. default disappears, Crescenzi says.

But the story doesn't end there. The current battle over the debt ceiling could just be the first act. Raising the government's borrowing limit to about $16 trillion would give the Treasury as little as 13 more months of breathing room, according to estimates from economists at Nomura Securities.

In that case, the next debt-ceiling showdown will arrive sometime next fall, just in time for the final months of the 2012 presidential election.

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