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By Steven C. Johnson and Richard Leong
July 24, 2011 3:35 PM EDT
Global financial markets have been more than patient throughout this summer's struggle over raising the U.S. debt ceiling. That patience may run out on Monday.
With the August 2 deadline a week away and an agreement still in question after talks involving U.S. lawmakers and President Barack Obama's administration faltered this weekend, investors may come to work facing the real possibility of a U.S. default and the loss of the country's prized AAA credit rating.
If the notion that the game of "chicken" over the nation's debt is going to end badly takes hold, Treasuries and the dollar could come under heavy selling pressure, driving up interest rates, damaging business confidence, and weakening an already fragile U.S. economy even more.
A slide in the bond market could trigger a wave of selling elsewhere, too, with stocks, money market mutual funds and higher risk assets elsewhere in the world all vulnerable as deepening problems in the U.S. would threaten to damage the global economy.
The kind of nightmare that keeps investors awake at night is a repeat of the chaos in 2008, when Congress' failure to authorize a $700 billion bank bailout sparked a global markets meltdown.
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"I'm not sure we're looking at total mayhem yet with the Asian open, but it's possible," warned Christian Cooper, head of U.S. dollar rates derivatives at Jefferies & Co. The next 12 hours are going to be critical."
A substantive deal that cuts some $3 trillion to $4 trillion from the deficit over the next 10 years would be met favorably by investors, but that will tough to reach now.
A two-step plan being pushed by Republicans to give the government enough borrowing authority to make it through the year while lawmakers work on long-term deficit reduction could allay some fears but could still lead to a ratings downgrade.
Standard & Poor's has said it might still cut the United States to AA if lawmakers embrace a short-term fix that lifts the debt ceiling but doesn't address long-term fiscal issues.
Many investors are still holding out hope for a debt deal even it were to occur a second before the clock strikes at midnight on August 2.
To be safe, though, trading and investment houses have built up their cash holdings and reduced their exposure to stocks and risky assets in case the U.S. does default.
LONG BOND, DOLLAR VULNERABLE
Throughout the debate, bond yields have held near historic lows, with the benchmark 10-year note trading below 3 percent. Investors say that reflected belief that squabbling politicians would not let things escalate to the point of actually risking a default.
"We believe Winston Churchill characterized the U.S. well when he said, 'You can always count on Americans to do the right thing after they've tried everything else,'" said David Kotok, chairman and chief investment officer at Cumberland Advisors in Vineland, New Jersey.
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