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Downgrade Adds Volatility as Markets Also Watch Europe

After the initial sting, Standard & Poor's downgrade of the U.S. credit ratingshould take a back seat to concerns about the health of the U.S. economy and efforts to resolve the European debt crisis.

Michele Constantini | PhotoAlto | Getty Images

U.S. stock futures were sharply lower Sunday evening, and equities markets globally were expected to be volatile. Treasurys were relatively steady in early trading with yields slightly higher on the long end of the curve, and lower at the short end. The dollar index was slightly lower in early trading.

"There are dual things going on here. The European bond crisis is more of an acute threat and risk than the S&P downgrade. As we speak about the bond market, these issues seem to overlap and intersect as if they are kind of one. They are separate and distinct. The S&P action is going to get headlines. We are going to trade it to a high degree or least other markets are going to trade it to high a degree, but at the end of the day it is going to be a ho hum (for the Treasury market)," said David Ader, chief Treasury strategist at CRT Capital.

Global financial officials worked over the weekend to provide guidance ahead of the open of markets. In Europe, the European Central Bank said it would activate its securities market program and it welcomed economic reforms and deficit cutting in Italy and Spain, a signal to markets that the ECB will purchase Spanish and Italian debt to stabilize markets.

The G-7 finance ministers also issued a statement, welcoming the ECB's moves and the measures taken by Italy and Spain. G-7 also welcomed "decisive" actions taken by the U.S. to adopt reforms and deliver "substantial deficit reduction over the medium term," in reference to the same plan found to be insufficient by S&P when it sliced the U.S. AAA rating to AA plus Friday.

G-7 also affirmed its commitment to take all necessary measures to support financial stability in growth in a spirit of "close cooperation and confidence."

"Even though the central banks are taking action, it doesn't seem to be as coordinated as it was after Lehman," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.

Wall Street firms also worked over-time this weekend, holding conference calls to address investor concerns. Several predicted further dollar weakness, but when it comes to the Treasury market, they said there is no replacement for it and it is unlikely to be greatly impacted.

There is no U.S. economic news expected Monday, but investors are likely to focus heavily on the Fed's regularly scheduled FOMC meeting Tuesday. "The Fed is likely to be more dovish," Chandler said.

He said among the things the Fed can do is to provide guidance on what it means for interest rates to remain low for a long time. The Fed could also discuss its asset purchases. "They've been buying mostly short-dated Treasuys. They could shift that and buy longer-dated Treasurys to flatten the curve and provide more stimulus to the economy," Chandler said.

While the Fed no longer purchases Treasury securities under QE2, its recently retired quantitative easing program, it continues to purchase Treasury securities with the proceeds from the roll down of its mortgage portfolio. Chandler also said it is unlikely the Fed would publicly discuss QE3, a new quantitative easing program.

"The bar is too high for QE3, partly because employment is stronger, inflation is rising, not falling. Real and nominal interest rates already are very low and each round of asset buying provides new challenges in terms of unwinding them," he said, adding the Fed would also wait for more data to see a clear direction for the economy.

Whither Stocks

Barclays chief equities portfolio strategist Barry Knapp said the stock market has been expecting the downgrade, and his firm does not expect it to have a major impact on the bond market.

"I would guess the first move (for stocks) would be lower when the S&Ps open up, but I think if people think through the ECB decision and if we walk in tomorrow and the ECB has bought the Spanish and Italian markets in decent size and those market stabilize, then I think Europe would be a bigger factor," he said.

"The downgrade itself is a psychological negative. In all my meetings last week, nobody asked about the downgrade. They asked about Europe and the U.S. economy. That was the concern," Knapp said.

Knapp said the slight improvement in payrolls Friday, the chain store sales and auto sales last week were all positive signs for the economy.

"The fact that the data stabilized in the U.S. so much last week was really important from our perspective," said Knapp. Markets Friday shrugged off the better than expected July jobs report which showed the creation of 117,000 non farm payrolls.

At the same time, economists have become increasingly negative on the economy and its ability to show much growth in the second half. Goldman Sachs economists Friday cut their outlook for second half growth to 2 percent with a one-in-three risk that the economy will go back into recession.

Goldman's stock strategists followed with a reduction in their forecast for the market, trimming their year-end S&P 500 target to 1400 from 1450.

Morgan Stanley's chief equities strategist Adam Parker, one of the more bearish, said Sunday that he expects the market to go lower. He notes that the S&P 500 last week closed below his year end target of 1238 for the first time.

Parker said he has been viewing equities earnings estimates as too high for the second half and next year. "Our view is the multiple is going to contract," he said. "That's been our view all year."

"While the market is pricing in a higher probability of recession than it was two weeks ago, it certainly is not pricing in a whole recession at this point. There's clearly more downside," he said. Morgan Stanley's forecast does not include recession. "But I would not be surprised if in the next couple of years, you had one," he said.

Citigroup chief U.S. equities strategist Tobias Levkovich said investors have seen government policy error as the biggest risk to the economy and stock market for the past year. He said the 12 percent stock market correction of the past two weeks already captures new economic, and earnings concerns but it does not appear to be signaling "genuine fear with the investment community."

In the note, he also said since investors have been seeking safety in high grade corporate bonds, they may also start to favor well capitalized companies. " Indeed, with corporate margins likely peaking out and valuation being relatively attractive, the largest US entities may begin to outperform after almost 15 years of underperformance," he wrote.

What Else To Watch

There are a few earnings reports Monday, including Tyson Foods, Scotts Miracle Gro, U.S. Cellular, Dollar Thrifty, MGM Resorts and Live Nation.

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.

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