By Ryan Vlastelica
NEW YORK (Reuters) - U.S. stock investors, hoping to leave politics aside to focus on fundamentals, aren't going to get their wish yet as talks over raising the debt ceiling and reopening the government broke down over the weekend.
The S&P 500 generated two days of strong gains in advance of the weekend on hopes an agreement to raise the $16.7 trillion federal borrowing limit was near.
But the snag was expected to cause selling pressure to resume as investors now believe the negotiations will come down to an October 17 deadline to increase the debt ceiling.
"There will probably be a negative reaction in the stock market, but I think the pressure is really shifting to Washington now," said William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Massachusetts.
The government has been partially shuttered since October 1. The shutdown has lasted longer than many expected, and while proposals from both President Barack Obama and congressional Republicans have been viewed as signs of progress, a final agreement remains elusive.
Bipartisan talks broke down in the House of Representatives and shifted to Senate leaders. House Republicans were pushing a debt ceiling extension that would last only six weeks, potentially producing another showdown in the middle of the holiday season. Democrats want to push the deadline at least well into the new year.
Senate Majority Leader Harry Reid said on Sunday that he had a "productive conversation" with Senate Republican leader Mitch McConnell, adding that he was "optimistic about the prospects for a positive conclusion" and would continue discussions.
"Stocks were all eager to rally when the two parties just began to talk. I think that twists and turns such as this were to be expected as part of Washington's typical kabuki theater act," said Gennadiy Goldberg, interest rate strategist with TD Securities in New York.
"We had been arguing that a deal was more likely early next week rather than over the weekend, and still expect a compromise to be reached in time to avert a full-blown crisis."
Still, with no accord reached a few days before the deadline, stress is likely to increase in the bond market. Short-dated bills maturing between late October and the end of the year traded at elevated levels as banks and money market funds shunned the securities for fear of a delayed or missed coupon payment.
Yields on overnight interest rates in the $5 trillion repurchasing market, where banks and Wall Street firms pledge their T-bills as collateral to raise cash to fund their daily operations, have risen as well.
"We're drifting into unchartered waters here," said Bonnie Baha, senior portfolio manager at DoubleLine Capital in Los Angeles.
"When major U.S. money market funds start worrying about the mark-to-market implications of this impasse, you know that this has become an issue that is more than just theoretical."
Business groups are speaking more openly about the dangers of breaching the debt limit. In addition, the government shutdown is affecting spending along with consumer confidence, as hundreds of thousands of workers have been furloughed.
INCREASE IN VOLATILITY
The S&P 500 <.SPX> is above its major moving averages, which could serve as support in the case of a market decline. The benchmark index is 0.9 percent above its 50-day moving average of 1,678.22, and 1.8 percent above its 100-day average of 1,662.53.
Many analysts have forecast increased volatility the longer the market goes without a deal. The CBOE Volatility index <.VIX> spiked this week above 20 for the first time since June. Trading in VIX futures suggested more concern about the near-term market trend as well.
Data showed investors were willing to pay more for protection against a slide in the S&P 500 now than three months down the road. On Wednesday, the spread between the VIX and 3-month VIX futures briefly hit its lowest since late 2011 at around negative 2.
That condition reversed on Thursday, when the market rallied sharply, but traders remained guarded against another jolt of volatility if progress remained stalled in Washington.
While most analysts said a default on U.S. debt would be catastrophic for the economy, they also said it was highly unlikely that a deal would not be reached.
Ken Fisher, who oversees $49 billion at the Woodside, California-based Fisher Investments Inc, said there was a "maybe 0.0001 percent chance" the debt ceiling would be breached.
"People have been saying that things are different this time, but Washington is just a distraction for markets, simple as that," Fisher said. "If a default was possible, you would see bond prices fall through the floor. Eventually you have to stop listening to the people crying wolf."
EARNINGS HEAT UP
Next week is a busy one for corporate earnings. Results and outlooks from banks may be the most important, as investors look for companies' comments on how the shutdown may affect growth and the impact of higher interest rates. Among the early indications, Wells Fargo
The first busy week of third-quarter results is led by bellwethers General Electric Co
"The shutdown will impact earnings growth some, but I expect the negative effect will likely be small," said Fisher. "We're clearly still in the middle phases of a bull market."
S&P 500 companies are expected to post earnings growth of 4.2 percent in the quarter, down from the 8.5 percent rate that had been forecast on July 1, according to Thomson Reuters data. Of the 31 S&P components that have reported thus far, about 55 percent have topped expectations, below the historical average of 63 percent.
While some government-prepared economic data will be delayed next week because of the shutdown, including consumer prices and housing starts, those still scheduled include the New York Fed manufacturing survey and Philadelphia Fed survey, both for October.
Monday is Columbus Day and a federal holiday. Stock markets will be open but the U.S. government will remain shut. The sniping from lawmakers, of course, never takes a holiday.
"I'm still optimistic they'll get this done, though. As we've learned before, for Washington there's nothing like the last minute," said Cabot's Larkin.
(Additional reporting by Angela Moon, Richard Leong, Steven C. Johnson, Jennifer Ablan and Rodrigo Campos; Editing by Kenneth Barry and Jeffrey Benkoe)