By Ellen Freilich and Chuck Mikolajczak
NEW YORK (Reuters) - A deal involving up to $3 trillion in deficit cuts over a decade that would let U.S. lawmakers raise the U.S. borrowing limit and avoid default could spur a relief rally in Wall Street stocks and a rise in U.S. government yields on Monday.
Senate Democratic Leader Harry Reid said on Sunday he hopes to hold a Senate vote tonight on an emerging deal to raise the U.S. $14.3 trillion U.S. debt ceiling.
The possibility of an agreement raised hopes that a bitter, weeks-long partisan battle over cutting the U.S. deficit might be near a close.
"At this point, the markets are perceiving that a deal and a vote will be announced," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.
The consequence of a debt deal will be "a relief rally in stocks," Krosby said. "There will also be an attempt to deconstruct the information: where the austerity will come from. You will see analysts try to dissect which sectors and companies will be impacted by the cuts."
Anxiety over the debt crisis and the U.S. economic outlook sent the S&P 500 lower last week, resulting in the worst week and month for the benchmark index since last August.
The CBOE Volatility index, Wall Street's "fear index," rose more than 40 percent, its biggest jump since May.
U.S. Treasury prices rallied last week as investors clung to relatively safe U.S. government debt and concluded that a weak economy meant the Federal Reserve would keep monetary policy accommodative for the foreseeable future.
A stock market rally prompted by a debt ceiling deal could be limited, however, by the U.S. economy's uncertain outlook, prospects that could be hurt by a debt ceiling plan based on fiscal austerity.
"Once the euphoria of having a deal is over, we will get back to the economy and that picture is not a pretty one," said Kevin Giddis, president of fixed income capital markets in Morgan Keegan in Memphis, Tennessee.
Government data released on Friday showed the U.S. economy stumbled badly in the first half of 2011 and came close to contracting in the January-March period.
"The market will quickly shift its focus to the employment data coming out on Friday," Krosby said. "A relief rally could fade if the data underscore that the economy is shifting into a stall, rather than sitting in a soft patch.
"The market (will) quickly focus on the data and on corporate earnings and corporate guidance," Krosby said.
Any relief enjoyed by the stock market would probably come at the expense of the U.S. Treasury market which benefited from its safe-haven status during the debt ceiling conflict. That would lead to higher U.S. yields.
Still, any rise in U.S. Treasury yields resulting from diminished anxiety about the debt ceiling would be limited by the troubled outlook for the U.S. economy, circumstances that appear to ensure that the Federal Reserve's monetary policy will remain accommodative for a long time.
The recent retreat in stocks has put them in a precarious position from a technical perspective as the S&P 500 index moves closer to its 200-day moving average, a level which could bring about additional selling if the index breaks below it.
The benchmark index successfully bounced off the level on Friday after the early morning decline.
"That is the line in the sand that really divides things going maybe bad -- to things really turning bad," said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.
Even if a deal is struck, a possibility remains the United States could lose its triple-A credit rating if the terms are not draconinan enough to satisfy credit rating agencies.
"You will hear analysts debate whether or not the package is sufficient to keep the ratings agency at bay in terms of downgrading U.S. government debt," Krosby said.
Investors can still find some solace in corporate earnings. According to Thomson Reuters data through Friday, of the 327 S&P 500 companies that have posted earnings, 73 percent have reported results higher than analysts' expectations.
Companies due to report earnings this week include Kraft Foods Inc, Clorox Co, Pfizer Inc and Prudential Financial Inc.
But a weak economy combined with a debt ceiling bill that involves more fiscal restraint could hurt stocks later on.
"Companies have been able to offset a lack of demand by refinancing their balance sheets, but longer term, the sledding will be much tougher for equities and corporations," Giddis said. "We have to improve job growth for businesses to do well or for the equity market to do well."
In addition to weak economic data, corporate earnings, and U.S. debt ceiling developments, investors must remain prepared for any developments from the simmering debt crisis in the euro zone, which could further heighten investor angst.
"There are two things I keep my eye on -- one on Washington and one on Brussels, because between the two of them you never know which headline risk is going to hit you over the head next," said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.
(Editing by Bernard Orr)