Global Markets Ahead: Investors straddle US default line

If ever there was a pivotal moment for financial markets, this could be it: The United States defaults and investors face the great unknown, or it doesn't and one of 2011's key risks is removed.

Not that the coming week does not hold other events of note. There are central bank rate decisions and a raft of significant economic reports, for example. The euro zone crisis is also rumbling on.

But far and away the most important issue for investors is Tuesday's deadline for Washington to raise its USD 14.3 trillion debt limit. To investors' dismay, approval is being held up by a bitter partisan squabble between Democrats and Republicans.

Without agreement -- and there was little sign of one, heading into the last few days -- the vaunted triple A-rated US economy could default by not paying all its bills, at least temporarily.

The issue for investors is that what happens next is unclear. For one thing, the August 2 deadline is not necessarily inviolate. For another, the US Treasury could decide it was a priority to keep paying its debt obligations, avoiding any short-term default.

In theory, however, lack of agreement could prompt turmoil on financial markets, with investors selling US debt, dumping other dollar-denominated assets, running away from global risk assets and scrambling into already overcrowded safe havens.

Gold , for example, has risen close to 10% in July alone, hitting a series of all-time nominal highs as investors have fled the twin US and euro zone debt crises. Similarly, the Swiss franc has soared against both the dollar and the euro in the month.

"We are suggesting that there could well be some more volatility. But we are not inclined to believe that volatility will last long," said Kevin Gardiner, managing director of research and economics at Barclays Wealth.

He said there might even be some opportunities created if assets such as US equities react negatively, making them cheaper.

A default, nonetheless, would raise huge questions about the supposed sanctity of the world's largest economy, triggering immense stress on US money market funds, tempting banks to stop lending to each other as in the Lehman crisis, and potentially tipping the country back into recession.

All clear?

If, on the other hand, negotiators in Washington succeed in raising the debt limit, an argument can be made that a relief rally of riskier assets would be in order.

Some of the pre-deadline positioning would almost certainly unwind, for example.

Investors clearly want to start raising their risk profiles. Reuters asset allocation polls released in the past week showed a moderate rise in equity exposure for the second month in a row.

At the same time, returns on mainstream assets this year, while poor, do not come close to reflecting the kind of news that has been thrown at them, from Japan's earthquake and tsunami to the euro zone crisis and turmoil in the Arab world.

What has been holding investors back most recently are the twin debt crises. If agreement is reached in Washington, that could combine with the Greek bailout agreed by the euro zone to lift some of the barriers.

"I think they are going to come up with something. There will be a certain amount of relief. There will be a bounce," said Christopher Potts, head of economics and strategy at brokers Cheuvreux.

But he said that for a longer-term return to the bull market, signs of diminishing inflation in emerging markets and better growth in the US economy were needed.

The debt issues, indeed, are not going to be solved simply by an agreement in Washington and the euro zone's second rescue package for Athens.

"We are going to be living with this for years," Potts said.

The United States, for example, remains under threat of a credit rating downgrade whether it agrees on the debt ceiling or not, raising fundamental issues about what institutions can hold US Treasuries.

Attempts by euro zone leaders to draw a line under the bloc's debt crisis and avoid contagion, meanwhile, already appear to be stumbling.

Yields on Italian 10-years bonds were close to 6% again on Friday and Moody's placed Spain's credit rating on review for possible downgrade, citing weak growth and funding pressures.

Spain added to investor nerves by calling an early general election for November.

Growth indidcators

All this should be enough to keep investors busy at a time when, traditionally, many of them are supposed to be away on summer holidays.

That they are not can be seen from volume on the FTSEurofirst 300 stock index, which is higher than it was in non-holiday season April and May.

But there are also plenty of other, more traditional investment triggers in the coming week to focus the mind.

The European Central Bank's rate-setting meeting on Thursday looms large as one. The bank has embarked on a tightening cycle but is not expected to raise rates this time.

Or at least it wasn't until Bank of France chief Christian Noyer said in the past week that the ECB was exercising "grande vigilance" on inflation - which if translated as "strong vigilance" would mean the bank was preparing a rate rise.

The Bank of France sought to clarify, saying Noyer meant "strong alertness", a phrase with a lot less resonance. But it was enough to make the meeting less routine than it might have been.

Investors will also be looking for the latest takes on how the US and euro zone economies are faring -- ultimately more important than the debt issues.

US and euro zone manufacturing surveys are due out as is the always closely watched US jobs report, a key gauge that filters down into consumer spending.