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Markets Face Tough Week With Debt Talks in US, Europe

Investor attention will swing between the U.S. and Europe as politicians on both sides of the Atlantic struggle with debt and deficits that hang like a threatening pendulum over markets.

NYSE trader
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NYSE trader

In the week ahead, the Congressional "super committee" is likely to come down to the final hour as it tries to find $1.2 trillion in budget deficits in time for a vote Wednesday.

Investor expectations are low that the bipartisan "super committee" will be able to put aside differences on taxes and spending cuts and come up with the full amount of reductions.

Goldman Sachs analysts handicapped the stock market's reaction to the committee's progress, warning the S&P 500 could lose 10 percent if the super committee fails to agree on reductions. If, as the analysts expect, the committee finds all, or at least part with the balance coming in automatic cuts, then the market would likely trade in the 1200 to 1250 range that it is in now, they said.

European officials, meanwhile, have so far failed to convince marketsthat they have a plan to stem the contagion from their sovereign debt crisis.

Italian, French and Spanish bond yields were under pressure in the past week as markets looked for definitive action from European leaders. Instead, German and French officials continued to publicly disagree over whether the European Central Bank should take on a bigger role and monetize debt. ECB President Mario Draghi Friday warned political leaders that they must find a solution.

"They need to start printing money," said Kevin Ferry of Cronus Futures. "The ECB has to realize Bundesbank or not, the German public is not necessarily on the hook for printing enough euros to get support back."

Ferry said the problem can be dealt with, but the European periphery countries are adopting austerity measures that cut growth, impairing their ability to pay their debt even more. "They've got to find a way to buy (German Chancellor Angela) Merkel and her political people some cover," he said. "If they would just step up. I think they need to monetize it."

Spain was headed to weekend elections, where it was expected the conservative Peoples Party would win in a landslide. Italy's new technocrat Prime Minister Mario Monti formed a new government this past week.

Growth Spurt

U.S. economic reports in the week ahead could continue to show improvement, possibly continuing to set up the fourth quarter as the fastest growing in the last year and a half. There are durable goods, jobless claims, and personal income and spending reports in the Thanksgiving-holiday shortened week. In the past week, several economists raised their fourth-quarter forecasts to 3 percent or more.

This coming week is also the official start of the holiday shopping season, a key time for retailers and an important measure of economic activity. More stores are opening on Thanksgiving Day this year in the hopes of getting a bigger share of the sales from the Black Friday rush.

While the U.S. economy looks betterand feels a bit better, there were clear signs of fraying around the edges in credit markets, signaling tighter financial conditions. Swap spreads, watched as metrics for credit risk, widened dramatically to some 2008 and 2009 levels in the past week. The spread between the 2-year swap and 2-year Treasury note yield, for instance, widened to over 52 basis points, signaling concern as it crossed 50 basis points. That spread, which hit spring 2009 levels, narrowed again as markets traded more calmly on Friday.

"You have to be concerned. There is a probability that's hard to assess that we could have another post-Lehman type period if things in Europe spin out of control," said Ed Keon, portfolio manager with Quantitative Management Associates. Keon said he is buying stocks — he's overweight on high quality U.S. stocks and emerging market equities, but underweight on European names.

"If you were just looking at the U.S. economic data and the third-quarter earnings data, you'd say stocks look pretty cheap here. But because you cannot dismiss the possibility of things in Europe dragging us down into global depression, you can't get that enthusiastic," Keon said.

"I think the odds are low, but nobody knows what the odds of that are," he said.

Analysts have been worried that as European bond yields rise, borrowing costs become unsustainable. This week, Spain paid nearly 7 percent to issue 10-year notes, and Italy's 5-year and 10-year yields rose above 7 percent several times. The concern is also that the strain adds to pressure on European banks, which are big holders of European sovereign debt. The ECB reports how much debt it bought in the past week on Monday.

David Ader, chief Treasury strategist at CRT Capital, said the Treasury market's current yield range reflects the better U.S. data at the same time concerns about Europe are driving buyers into the bond market. He noted that in the past week foreign central banks bought up $31.7 billion in Treasury securities, the fifth biggest week ever. The 10-year Treasury bond finished the week with a yield of 2.012 percent, lower on the week.

"If we were trading just U.S. events, yields would be 35, 40 basis points higher, at least in the 10-year," Ader said, adding that the interbank lending market is showing clear sings of duress.

"The whole bloody thing worries me," Ader said. "The central banks of the world can provide the liquidity ... that doesn't mean everything is fine and well."

Fed Ahead

The Fed on Tuesday is expected to release the minutes of its last meeting, which will be scrutinized by investors for any discussion of what might trigger more easing. Fed officials, in a number of speeches in the past week, spoke on both sides of the easing issue. Chicago Fed President Charles Evans, the lone dissenter at the last meeting, told a meeting at the Council on Foreign Relations this week that 9 percent unemployment requires action. "We ought to be behaving like there's a really big problem out there," he said.

Fed officials have said they would consider a third quantitative easing program, if needed. The last program, QE2, ended in June and involved the purchase of $600 billion in Treasury securities. This time, the Fed is expected to focus on mortgages, in an effort to drive mortgage rates lower.

"They're discussing all kinds of policy options and scenarios, and they've been talking a lot with Europe. Unlike 2008, they have more time but fewer tools. It will be interesting to see what scenarios they are discussing," said Diane Swonk, chief economist at Mesirow Financial.

The Dow in the past week fell 2.9 percent to 11,796, and the S&P 500 was down 3.8 percent at 1215. The Nasdaq declined nearly 4 percent to 2572. The worst performers were financial stocks, down 5.6 percent for the week. Materials stocks, affected by commodities prices, were down about the same. Natural gas was among the biggest losers in commodities, down more than 7 percent on the week, while silver was down 6.5 percent. The euro was down 1.7 percent on the week, finishing Friday at 1.3524.

Brian Dolan of Forex.com said the euro could be very vulnerable to a further decline to 1.30/1.31 if it gets down to 1.34.

"We've got the U.S. holiday. We could bounce around in a range in the next week ... there's a tendency to be major breakouts around U.S. holidays" in both directions, he said.

What to Watch:

Monday

Earnings: Hewlett-Packard , Analog Devices, Brocade

1000 am Existing home sales

0100 pm $35 billion 2-year Treasury note auction

Tuesday

Earnings: Campbell Soup, Chico's FAS, Hormel, Medtronic

0830 am Real 3Q GDP (second)

1000 am Richmond Fed

0100 pm $35 billion 5-year Treasury-note auction

0200 pm FOMC minutes

Wednesday

Earnings: Deere

0700 am Mortgage applications

0830 am Initial claims

0830 am Durable goods

0830 am Personal income and spending

0955 am Consumer sentiment

1100 am Kansas City Fed survey

0100 pm $29 billion 7-year Treasury-note auction

Congressional "Super Committee" deadline to vote on deficit reduction recommendations

Thursday

Thanksgiving Holiday

Friday

Stock market closes at 1 p.m.

Follow Patti Domm on Twitter: @pattidomm

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