By Steven C. Johnson
NEW YORK, July 25 (Reuters) - Gradually, then suddenly.
Ernest Hemingway's description of how a man goes broke may sum up how investors could react if the United States fails to raise the debt ceiling by Aug. 2 to stave off default.
While stocks, Treasuries and the U.S. dollar slipped on Monday as it became clear the debt ceiling debate would go down to the wire, there was no sign of the panic some had feared.
But next Monday, one day ahead of the critical deadline, market reaction could be swift if lawmakers are still far from a deal, investors and analysts said. That's when the prospect of a U.S. default and ratings downgrade could really sink in.
"Nobody is going to believe the U.S. will actually stop paying its bills until that happens," said Hugh Johnson, chief investment officer at Johnson Illington Advisors in Albany. "So I think it we'll have to hit the wall" before markets panic.
Say what you will about Wall Street, but it has been consistent throughout the summer's debate. Investors have long predicted Republicans and Democrats would go down to the wire before agreeing to raise the $14.3 trillion borrowing limit.
"We really have to get right on top of the deadline," said Nick Kalivas, senior equity analyst at MF Global. "Come Monday, there will probably be a more significant reaction. My guess is that's when people will get really concerned."
Many still think a deal will be done, even though agreement on a long-term deficit reduction plan -- a Republican-mandated prerequisite for raising the debt ceiling -- appears far off.
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"Markets will be forgiving until they give up on reaching a compromise," said Richard Bernstein, chief executive at Richard Bernstein Advisors. "Even leading up to the (bank bailout) vote in 2008, markets gave Washington the benefit of the doubt until they managed to completely mess it up."
That's the rub. When Congress failed after Lehman Brothers' 2008 collapse to authorize a $700 billion bailout for troubled banks, world markets sold off violently.
If the United States were to default and ratings agencies cut its prized AAA credit rating, investors fear a repeat of that sort of market chaos.
A downgrade could ripple through markets because Treasuries are considered the world's "risk-free" asset on which countless other asset prices are based. The dollar, stocks, municipal debt and risky overseas assets could suffer collateral damage.
"We could see a shock, but I would think it would come on Aug. 2 or 3," said Peter Demirali, portfolio manager at Cumberland Advisors in Vineland, New Jersey, with $1.8 billion under management. "I don't think they will sell off earlier unless somebody comes out and drops a bomb and says we're going home for good."
COUNTDOWN TO AUG. 15?
Some analysts say Wall Street may also be betting that Aug. 2 is a soft deadline. In a note to clients, Barclays Capital analysts said stronger-than-expected tax receipts since July 14 "suggests the date on which the Treasury will run out of cash to pay its obligations might be around Aug. 10 instead."
That would only provide a bit of breathing room, however, since Treasury faces $25.6 billion in quarterly interest payments on coupon-bearing Treasuries by the middle of August.
"We've got a lot of coupon payments on Aug. 15, that's really the date we need to watch," said Priya Misra, rates strategist at BofA-Merrill Lynch.
She said Treasury can make debt maturity payments up to that date, but "Aug. 15 is when they either prioritize or miss.
"If they miss coupon payments we know exactly what the securities are," she said. "The price of the securities would move drastically that day and you would see a tiering. The next coupon securities would start underperforming much sooner."
Kalivas said he was watching the rates on bills with payments due in early August for signs of stress. Treasury was forced to pay higher rates on fresh three- and six-month bills sold on Monday. He said sales for two-, five- and seven-year debt would also be watched for foreign participation.
"If dealers are having to buy more of this than what we've been seeing the markets might get concerned," he said.
SPOOKING THE STOCK MARKET
But it might not be bonds that get hit hardest. A Standard Chartered report showed that when deadlock over the debt ceiling forced the U.S. government to close down in 1995, yields fell while stocks suffered on concerns about growth. There was no real concern in the market at that time, however, that the United States might fully default.
Jane Caron, who helps manage $53 billion at Dwight Asset Management in Burlington, Vermont, said stocks may be the canary in the coal mine this time, too.
"Those who wanted to raise cash and get out of the long end of the bond market have done that already, so you don't want to chase that trade now," she said. "You could get whipsawed if they reach a deal at the last minute."
"What I'm watching is the equity market because I think investors there are more inclined to get spooked this week," she said, adding, ironically, that a move out of stocks would probably boost shorter-dated Treasuries.
Currency strategists said the dollar would likely hold up until it was absolutely certain that a deal would not be reached by Aug. 2.
While a default or a downgrade would push the dollar lower against safe havens such as the Swiss franc, Europe's own debt problems might keep the dollar fairly well supported against the euro, said Firas Askari, head of trading at BMO Capital Markets.
"The spectacular lack of statesmanship and increased amount of brinkmanship in the U.S. sure aren't encouraging," he said, "But I am even more worried about the euro right now." (Additional reporting by Karen Brettell; editing by Leslie Adler)