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The Associated Press July 31, 2011, 7:26PM ET

Deal or no deal? Markets bracing for Monday

Investors around the world remained on edge Sunday as Congress continued to work on a deal to raise the country's borrowing limit and avoid a U.S. debt default.

Japan's benchmark Nikkei index is the first major stock market to open for trading, on Sunday at 8 p.m. Eastern time. But there's already some evidence that investors believe a deal will be made before U.S. markets open Monday.

Shortly after Sen. Democratic leader Harry Reid said he had signed off on a deal reached late Sunday between the White House and Republican leaders, Dow futures were up 125 points, or 1 percent. Future contracts for the broader S&P 500 index rose 1.2 percent. When futures are up during off-hours trading, stocks typically rise when the market opens.

If a deal is reached to raise the borrowing limit, John Brady, a senior vice president for futures and options at MF Global said that the Standard & Poor's 500 index could add 6 percent in the next few weeks.

"Stocks will rally, and stocks will rally big," Brady said Sunday. "The markets are giving heavy odds that this deal is going to get done."

A deal would remove a major source of something investors hate: Uncertainty. But there's another reason the so-called relief rally might be a big one. Companies have reported strong earnings in recent days, but traders have been reluctant to buy stocks fearing the debt wrangling in Washington might set off a financial crisis.

If there is no agreement to raise the nation's borrowing limit and defuse the building financial crisis, analysts said Sunday they expect stock markets across the globe to fall on Monday.

In the U.S. that would add to six straight days of stock losses. The Dow Jones industrial average fell 581 points, or 4.6 percent, in that time.

Brady predicts the S&P 500 could fall another 7 percent on Monday if a deal falls apart. The S&P closed at 1,292 on Friday and was down 3.9 percent last week. A loss that big could send the S&P down to 1,200, a level it hasn't reached since last November.

The Treasury Department has said that after Tuesday the U.S. government won't have enough money to meet all of its financial obligations if Congress does not raise the nation's debt ceiling. If a deal is not reached, the Treasury Department will have to decide which bills to pay and which to delay. Among them: interest payments on bonds, salaries of federal employees, and Social Security payments to retirees. The Treasury Department has not indicated which payments will take priority if the debt ceiling is not raised.

Thomas Tzitzouris, head of fixed income research at Strategas Research Partners said Sunday that to avoid a steep decline, the market needs to at least see some progress toward a vote on a deal to raise the borrowing limit.

If not, he said: "That would be a double whammy. When (Congress says) there is progress and then there isn't, that really spooks the market."

That's what happened last week when a series of proposals gave investors fleeting hope for a deal. That is, until one party or the other shot them down. Nearly every measure of market confidence fell last week as Aug. 2 approached. The price of gold rose 2 percent for the week. Many investors tend to buy gold -- sending the price higher -- when they aren't confident about other investments. A measure of stock market volatility, the VIX, jumped 6 percent.

In turn, the yield on the 10-year Treasury sank to its lowest level of the year on Friday, 2.80 percent. Treasury yields fall when demand for them goes up. Demand tends to rise when investors are reluctant to put money in stocks. Treasury bonds have long been considered the world's safest investment and are a top holding of the largest pension funds in the U.S., the Chinese government and millions of Americans who own mutual funds.

"If this issue can be taken out of the headlines and the focus on Washington can be redirected toward corporate earnings and economic fundamentals, the market will have removed a significant obstacle," said Quincy Krosby, chief market strategist at Prudential Financial.

Corporate earnings have been strong so far for the second quarter. Many major U.S. companies have reported their earnings in the last three weeks and others such as consumer goods companies Procter & Gamble and Kraft Foods will report this week.

"When you look at corporate earnings, which are immune to politics, you see that companies have been knocking the cover off the ball," said Douglas Cote, the chief market strategist at ING.

Despite weak economic growth in the U.S., corporations in the S&P 500 are on pace for record profits for the year. That's largely because those companies now make nearly half of their revenues overseas.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, said even a tentative agreement should energize the markets on Monday-- "just for the resolution alone."

"Any deal that forestalls a technical default is going to be greeted by at least a 200-point move to the upside on the Dow," he said Sunday.

While plenty of other challenges loom ahead politically and economically, Ablin said the market already has built-in enough of a negative outlook to be able to absorb those bumps.

Among those challenges: A report Friday said that the U.S. economy grew at an annual rate of only 1.3 percent between April and June. This year, the economy has grown at its slowest pace since the recession ended in June 2009 -- just 1.7 percent.

A debt deal that significantly cuts short-term government spending could further weaken the economy, experts say.

Analysts say companies won't be ready to hire and invest in new projects until some other Washington issues are resolved, like the cost of health care legislation passed last year and financial reform legislation.

Mark Luschini, chief investment strategist, Janney Montgomery Scott investment firm in Philadelphia, expects a market rally once a deal is reached. But then he says attention would turn very quickly to the jobs report that will be released on Friday. Economists expect that it will show 110,000 jobs were added by employers in July, according to FactSet. That's still well below the level that would indicate healthy job growth.

Analysts say if a deal is reached before Aug. 2, investors will chalk up the market-rattling debt drama as another example of ultimately harmless Washington theatrics.

If the current deal falls apart, however, they say politicians will have done lasting damage to the nation's credibility. Over time, this could make U.S. government debt less desirable to the worldwide market. That, in turn, could raise the cost of borrowing for the U.S. government.

Some lawmakers expressed optimism that a deal could yet be reached Sunday. A number of other promising deals have fallen through in recent days. This has left investors frustrated at Washington for adding to the economic uncertainty by failing to reach a deal before the deadline became so close at hand.

Uri Landesman, the president of Platinum Partners, a New York hedge fund said Sunday that this crisis is worse for markets than any he has seen before. He says that's because it comes at a time when the economy is weak and because Congress is much more divided that it was even during the financial crisis of 2008.

"There has been incredibly weak leadership all the way around," Landesman said.

--AP Business Writer Dave Carpenter contributed to this report from Chicago.

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