GLOBAL MARKETS-U.S. short rates leap on default fear, stocks fall

Reuters

* Weak demand for U.S. short-term bills highlights debtworries

* High-flying stocks hit as investors pull back from gains

* Dollar edges off near 8-month low vs major currencies

* World share markets, oil, trade in narrow ranges

By Barani Krishnan

NEW YORK, Oct 8 (Reuters) - Interest rates on one-month U.S.government debt hit a 5-year peak on Tuesday and stocks on WallStreet closed lower as anxiety rose on whether the United Stateswill avert a debt default.

With the partial U.S. government shutdown in its second weekand only nine days left for Congress to act before an Oct. 17debt ceiling deadline, markets showed increasing signs of worry.President Barack Obama said he would accept a short-termincrease to avoid a default but negotiations have not proceeded.

Obama suggested Republicans were resorting to "hostage"tactics, demanding concessions before raising the federalborrowing limit or passing a budget that would end the partialgovernment shutdown that began last week.

Yields on short-dated bills maturing in the next few weeksrose sharply, and the Treasury sold $30 billion in four-weekbills at 0.35 percent, the highest yield since October 2008.Demand was the weakest in four-and-a-half years, as investorshave become concerned about the potential for a missed paymentif the Treasury's borrowing authority is not extended.

"This is the canary in the coal mine," said Eric Green,global head of rates, currency and commodity research at TDSecurities in New York. "You could see this seep into othermarkets. The next shoe to drop is for stocks to drop further.That's why you want the safety of gold and longer-datedTreasuries."

For its three-year auction, the Treasury sold $30 billion at0.71 percent, indicating more demand for longer-dated issues.

The one-month T-bill rate rose above theone-month London interbank offered rate, or LIBOR,for the first time at least 12 years, according to Reuters data.

One-month U.S. yields were at 0.36 percent, nearing the sameyield as two-year notes, at 0.37 percent. A surveyfrom J.P. Morgan Securities released on Tuesday showed investorscontinued to raise their holdings of longer-dated Treasuries, inlieu of short-dated bills.

The benchmark 10-year U.S. Treasury note wasdown 2/32, its yield at 2.6375 percent.

Wall Street's technology-heavy Nasdaq index dropped morethan 2 percent at one point after Obama said economic shutdowndue to a default would raise the risk of a deep recession.

The Dow Jones industrial average ended down 159.71points, or 1.07 percent, at 14,776.53. The Standard & Poor's 500Index was down 20.67 points, or 1.23 percent, at1,655.45. The Nasdaq Composite Index was down 75.54points, or 2.00 percent, at 3,694.83.

Global stocks as indicated by the 45-country MSCI worldequity index were off 0.7 percent.

Many investors believe Republicans and Democrats can stillreach deals on the budget and the debt ceiling. Obama concurredas much by reiterating on Tuesday that the United States hasalways paid its bills.

Such optimism is causing many investors to bank on a rallyonce the budget and debt ceiling fights are resolved. Whilestocks are on the decline, the broad S&P 500 has fallen by onlyabout 3 percent from all-time highs reached in September.

Even so, worries about a default are taking hold among some.The CBOE Volatility Index, a measure of Wall Street'sanxiety, rose to 20.66, up from Monday's 19.41 and the firsttime that index has hit 20 since June, a sign of rising concern.Technology stocks were the worst performers of the day, with theS&P information technology index down 1.3 percent.

"In our opinion markets are a little too complacent. Thedownside risks are horrendous if there is no resolution and thedebt ceiling is breached," said Kevin Corrigan, head of creditat Lombard Odier Investment Managers.

European equities ended down for a second straight session.The broad FTSE Eurofirst 300 index dipped 0.8 percent.

DOLLAR VULNERABLE

The dollar fell against the perceived safety of the yen totrade at around 97 yen. It had dropped earlier to 96.55yen, its lowest since Aug. 12.

The dollar index, which measures the U.S. currency's valueagainst a basket of currencies, was up slightly butwithin striking distance of last week's eight-month low of79.627. Traders said the currency remained vulnerable to moreselling.

The longer the political deadlock runs, the greater theeconomic damage and the more likely the Federal Reserve willmaintain its stimulus program, which has flooded global marketswith dollars. The biggest U.S. creditors, China and Japan, havesaid they are increasingly worried the developments inWashington could wreak havoc on their trillions of dollars ofinvestments in U.S. Treasury bonds.

Banks and investors outside the United States were moving toensure a steady supply of dollars to cover the criticalmid-October period when the government hits the borrowing limit,paying sharply higher premiums in the forward foreign exchangemarket.

Gold prices were little changed at around $1,320 an ounce, while benchmark Brent crude oil settled up 48cents at $110.16 a barrel and U.S. crude finished up 46cents at $103.49.. But the gains were expected to beshort-lived given an improved supply outlook and fallout fromthe U.S. budget crisis.

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