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Tuesday Look Ahead: Washington's Politicking on Deficit Will Keep Markets on Edge

Debt talks will again dominate Tuesday, as markets increasingly worry political cat fighting will lead to a weak deficit reduction deal, causing the U.S. to lose its top-notch credit rating.

Housing and consumer confidence data, plus a bucketful of earnings reports, should also get some investor attention.

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Stocks sagged Monday after a weekend of back-and-forth on the debt talks that left some investors concerned a deal to raise the debt ceiling might not get done. The Dow lost 88, or 0.7 percent to close at 12,592, a more modest hit than many had expected. The S&P 500 lost 7 points to 1337. Treasurys sold off, driving the 10-year yield above 3 percent. The dollar was mixed but lower against the yen and Swiss franc, and gold settled at a record $1,612 an ounce as investors embraced it as a safety play.

"It's all about the budget today, and that's really what the market's going to have to key off of for the next couple of days... so despite the fact we'd love to focus instead on earnings, we're going to have to deal with the fact that we have this one event that's still sitting out there that has to be dealt with," said Marc Pado, market strategist at Cantor Fitzgerald.

Pado said Moody's downgrade of Greece Monday, after the EU struck a plan last week to involve the private sector in its bailout last week reinforced the idea that a downgrade could come even if the debt ceiling is raised and some cuts are made.

As the Aug. 2 deadline to raise the debt ceiling draws near, financial markets are increasingly concerned that the political feuding will result in a deficit reduction plan that does not satisfy ratings agencies, resulting in a threatened downgrade to the triple A credit rating of the United States.

Strategists differ on what the reduced credit rating would mean for markets and what cascading affect it might have. But most agree it would put upward pressure on rates. Student loans could be affected, since they rely on the U.S. credit rating, and some funds that are required to hold triple A securities could be forced to sell Treasurys.

"I don't think it's going to be as catastrophic as some people make it out to be. It would certainly drive short term paper yields up," Pado said.

Pierpont Securities chief economist Stephen Stanley said it's too early to tell what economic impact would be of the various deficit reduction plans. "You're looking at a possible debt downgrade and what does that mean for the market... I'm not sure it has to be a disaster. Presumably Treasury rates will rise. It won't be a positive for the Treasury market, but I'm not sure it's a 2008 type event," Stanley said.

Bond traders see a temporary negative for Treasurys, but since the U.S. would not default, some believe the negative impact on other assets could make Treasurys attractive.

The markets have been watching deadlines slip away, as political leaders fail to bridge ideological differences. On Monday, Senate Democrats agreed to give up revenue enhancements, or tax hikes, which had been a big obstacle for Republicans. But Republicans refused to give up a demand that the debt ceiling be raised in steps, which would mean another vote on it next year.

"I think the single biggest loss here is the loss of credibility," said Boris Schlossberg of GFT Forex. "That's the biggest take away from this fiasco. There's just a massive loss of credibility on the part of fiscal officials to communicate to the market."

Schlossberg said the currency market could begin to reward some currencies even more in coming weeks if it is dissatisfied with the outcome. "That's actually bearish dollar against the euro. Bearish dollar against the Swiss franc. Typically commodity currencies are inextricably connected to risk. What you're starting to see in the currency market is a divergence away from that dynamic. People are starting to buy commodity currencies based on their superior balance sheet composition. They are becoming less of a risk trade and more of a safe haven play," he said, pointing to the Australian and Canadian dollars.

Tuesday's markets will get Case-Shiller home price data at 9 a.m. ET, and new home sales for June at 10 a.m. Consumer confidence is also reported at 10 a.m. Major earnings reports are expected from BP, Ford, 3M, Hershey, Lockheed Martin, Valero, UPS, Cummins, Occidental Petroleum, Illinois Tool Works, U.S. Steel, JetBlue, and T. Rowe Price. After the bell, reports are expected from Amazon.com, Electronics Arts, Dreamworks Animation and International Game Technology.

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High-flying Netflix stumbled after Monday's bell, dropping nearly 10 percent after it released softer than expected sales and a third quarter forecast shy of analysts' estimates. Broadcom rose after the bell when it beat expectations, but Texas Instruments was another disappointment, providing a slightly weaker-than-expected third quarter outlook.

Apple was also moving in after-hours trading, rising a half percent, on top of a 1.3 percent move during the day. The stock was at an all-time high close of $398.50, after crossing above $400 for the first time during the Monday trading session.

The Treasury auctions $35 billion in 2-year notes at 1 p.m. Tuesday. IMF Managing Director Christine Lagarde also speaks in New York at the Council on Foreign Relations at 8 a.m. on the world economy and the IMF.

Questions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.