Markets in limbo as debt deadline nears

NEW YORK — There's some signs of distress in financial markets — but no panic — as political gridlock grinds on and at least one ratings agency warned of a U.S. credit downgrade.

Still, investors are nervous, and financial markets are in limbo as they wait to see if Congressional Democrats and Republicans can strike a budget deal in time to avoid a debt crisis that could cause the U.S. to default on its debts for the first time.

The clock is ticking closer to the key Oct. 17 deadline that will either return sanity to Wall Street or cause potential chaos. On Thursday, the U.S. won't be able to borrow any more unless lawmakers act to extend the debt ceiling. Barring an agreement, the U.S. won't be able to pay all its bills.

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The biggest risk is if sometime after Oct. 17, the U.S. misses interest or principal payments on government debt it has already issued. Such a default could undermine the world's confidence in a financial asset that's long been viewed as the safest investment on Earth. Due to political brinkmanship, Fitch Ratings cited the potential hit to confidence as a reason it placed the USA's AAA rating on "rating watch negative." Standard & Poor's, of course, downgraded U.S.debt to AA+ in the summer of 2011 after the last debt-ceiling fight.

"The problem with the U.S. not paying investors on time is that it can destroy the very special status of Treasuries as a super-safe, liquid investment," says Boris Rjavinski, an interest rate analyst at UBS. "Treasuries are like an invisible glue that binds all of the world's financial markets. We can have a pretty bad chain reaction if there's a default."

The fallout of a U.S. default would be so unpredictable and potentially damaging to the financial system that few people on Wall Street think Congress would let such a self-inflicted wound occur.

"We have to assume that it is in no one's interest for the government to default," says Rob McIver, co-portf! olio manager at Jensen Quality Growth Fund.

That's why the stock market has navigated Washington gridlock nicely so far. Despite a 133-point drop for the Dow Jones industrials on Tuesday after Congress failed to sign a deal, the Dow is still up 0.25% during the 15-day government shutdown. If the deadline passes without a deal, however, stocks would likely suffer a "strong negative reaction," says McIver. If a deal gets done, the market will refocus its attention on corporate earnings and economic growth, he adds.

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But there have been more concrete signs of worry in the U.S. government bond market, especially one-month Treasury bills that will come due between Oct. 17 and early November, when the nation is expected to run short of cash.

Many banks and big investors have been selling these short-term instruments that could be hit by a potential default, says Bill Hornbarger, chief investment strategist at Moneta Group.

"Everyone is selling stuff that matures in October," he says.

A Treasury bill that matures on Oct. 24, seven days after the nation's ability to borrow ends, has seen its yield jump from roughly 0% in mid-September to more than 0.40% in recent days, according to a Bloomberg chart supplied by Rjavinski.

The issue isn't that investors don't think they will get paid back eventually, says Rjavinski; it is that they won't get paid on time.

"It's telling us investors are getting nervous," says Rjavinski.