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Debt ceiling drama could soon weigh on stocks, strategists warn

The potential for Congress to not raise the government's debt ceiling when it returns in September from its recess may begin to weigh on equity and currency markets.

The stock market rally has partially been hinged on hopes that the Trump administration will enact some sort of tax reform in the second half of the year. But mounting political tension may finally start impacting Wall Street heading into the fall, said Boris Schlossberg, managing director of foreign exchange strategy at BK Asset Management.

"Rumblings out of D.C. that the GOP will not pass a clean debt ceiling bill are already starting to weigh on the dollar, and investor concern may soon start to spill over into equities," Schlossberg wrote Tuesday in an email to CNBC.

The decision could have significant implications on the markets because the Republican Party seems to be "backing off the idea" of a "clean" debt ceiling. A "clean" debt ceiling refers to a lifting or suspension of the agreed-upon cap on federal borrowing capacity without any additional provisions. The likelihood of this passing is unlikely, Republican Rep. Tom Cole said Tuesday on MSNBC.

"If they attach any sort of conditions, that could create a stalemate in Washington, D.C., and actually put the U.S. Treasury at risk of default, so it could be a very serious concern for the markets as we get into the fall season," Schlossberg said Tuesday on CNBC's "Trading Nation."

He added: "What happens, for example, if they go for a month or two at a stalemate? It becomes very difficult for the U.S. government to function, for the Treasury to pay its bills ... for all the basic necessities of government to function well."

This would create friction in the economy and generally slows down the economy simply because of the "inertia that happens with the federal government," he said.

In 2011, a highly dramatic debt ceiling "crisis," in which Congress failed to raise the debt ceiling until it seemed to become immediately necessary, led Standard & Poor to downgrade the credit rating of U.S. and generated considerable market volatility. Yet that year as well as in a similar situation in 2013, Congress eventually agreed that the government could indeed borrow more money.

The markets could become more volatile as the debt ceiling deadlines approach heading into the fall, strategists at Bank of America Merrill Lynch wrote Tuesday in a note to clients. And this issue, along with the federal budget for fiscal 2018, could come to a head in the fall, they wrote.

"Regardless of how the events unfold, the collision of the budget and debt ceiling deadlines in September and October could spark market volatility and also a flight to quality, especially, ironically, Treasury securities," the strategists, led by fixed income strategist Martin Mauro, wrote.

In a note to clients Monday, HSBC's chief U.S. economist, Kevin Logan, wrote that he expects the ceiling will be raised, "but a crowded legislative calendar creates potential risks on the timing of an increase." Furthermore, under a passage entitled "Debt ceiling distractions," Logan wrote that indeed the country has been through debt default "scares" several times in the past decade, and each time Congress delayed raising the ceiling until the deadline was nearly reached.

"The same scenario is likely to play out this year, in our view, but there is always a possibility that political disputes will hamper efforts to raise the debt ceiling in a timely way," Logan wrote.

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Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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