Investors would balk at a possible move by Congress to raise the U.S. government's legal borrowing limit for only a short time, even if it bought lawmakers more time to work out a long-term solution.
A temporary fix could weaken the U.S. dollar, push up Treasury yields and invite further warnings of possible credit downgrades from ratings agencies.
Market strategists increasingly fear that weeks of budget talks, led by U.S. Vice President Joe Biden, are making too little progress, heightening chances that politicians will head down a potentially dangerous route for markets.
Frankly, we are on the path of just muddling through. We will probably promise some solution, but the details will be missing, said Adnan Akant, head of foreign exchange at Fischer Francis Trees & Watt, a New York unit of BNP Paribas with about $48 billion under management.
Foreigners would take that seriously. It would push you toward the Swiss franc and the yen, he added.
Delaying hard decisions would increase market uncertainty, said Ken Fisher, founder of Fisher Investments, with about $38 billion under management.
The muddle-through notion ... requires another decision later to kick the can down the road, and then you don't know how it'll get kicked the next time. So it brings fear that the next time it'll get kicked worse, he said.
A Republican leader said on Sunday that lawmakers could raise the U.S. debt ceiling just enough to allow discussions on a comprehensive budget deal that includes cuts in government benefit programs to continue for a few more months.
Senator Richard Durbin, the No. 2 Democrat, said on Wednesday the Biden talks just are not going to be able to accomplish a comprehensive deficit-cutting agreement before the August 2 deadline when the U.S. Treasury runs out of extraordinary measures to avoid missing debt payments.
Instead, they are looking at a deal to carry them through the presidential elections in November 2012, Durbin said.
Investors fear, however, that delaying crucial political decisions over spending cuts and taxes would polarize positions in Congress and turn the budget deficit into an electioneering football, making an agreement even more difficult.
Postponing action until 2012 would almost certainly cost the United States its coveted AAA credit rating, further raising interest rates for businesses and households and weighing on a fragile economic recovery.
Washington has been discussing two separate issues that became embroiled in one messy debate -- raising the nation's $14.3 trillion debt limit in order to avoid a technical default in August and working out how to balance the budget in the medium to long term.
Republicans' decision not to raise the debt ceiling until Democrats agree to deeper budget cuts has raised prospects that the Treasury could indeed miss debt payments in August, a move that would trigger sharp downgrades by Moody's, Standard & Poor's and Fitch.
For now, most investors believe such a technical default is unthinkable, so they are not pricing in that possibility.
I don't think investors are taking the possibility of the debt ceiling not being raised -- or the U.S. Treasury not being able to make an interest payment -- seriously, said James Barnes, senior fixed-income portfolio manager at National Penn Investors Trust Company in Wyomissing, PA.
Based on where the market has been trading, it's not a focal point for investors.
Still, long-dated Treasuries yields could rise just as they did in 1995-1996, the last time investors witnessed a U.S. debt ceiling stand-off.
In late 1995, when it became clear that the negotiations were breaking down, the market reacted violently and the (yield) curve steepened about 70 basis points, driven almost entirely by an increase in long rates, described Stewart Taylor, senior trader at Eaton Vance investment-grade fixed income, with $5 billion under management.
At that time, however, the U.S. economy was doing much better and the Federal Reserve was beginning to raise interest rates, so it is difficult to single out what really drove yields higher, Taylor added.
In any case, a muddle-through type of solution to U.S. debt problems would likely trigger even stronger warnings ratings agencies and markets, which could be just what Washington need to move faster.
That could leave us looking at a maelstrom of headlines by the ratings agencies by September which could in turn persuade lawmakers and the administration to take stronger measures down the road, said Robert Tipp, chief investment strategist for Prudential Fixed Income, with $240 billion under management.
As we see in Greece, it often takes a great deal of pressure from the financial markets to get action out of politicians.
(Additional reporting by Ellen Freilich, Emily Flitter, Steven C. Johnson and Nick Olivari; Editing by Stella Dawson and James Dalgleish)