Markets on edge as debt limit debate drags on

The word of the day in financial markets: Anxious.

Stocks fell in volatile trading Friday after a dismal report on economic growth added to a growing sense of unease as the federal government neared an Aug. 2 deadline to raise the nation’s borrowing limit. If Congress fails to act, the U.S. may not be able to pay all its financial obligations after Tuesday, including interest payments on bonds and the salaries of federal employees. A default on U.S. Treasury debt could wreak havoc on financial markets and the economy.

Major indexes fell sharply in early trading but erased about half of their losses after President Barack Obama said there were many paths to a compromise on raising the debt limit. The Dow Jones industrial average was down 42 points at 12,202 in early afternoon trading.

The combination of bad economic news and growing worries about a possible debt default were evident in nearly every measure of investor confidence:

? The Dow Jones industrial average was headed for its sixth straight day of losses.

? Nine of the 10 industry groups in the S&P 500 stock index fell.

? Bond yields fell as more investors sought safer investments.

? A measure of stock market volatility rose nearly 5 percent.

? The cost to protect against a U.S. default within the next year reached a record high. The cost to insure Treasurys for one year jumped 54 percent this week.

The Standard and Poor’s 500 index lost 2 points to 1,298 in afternoon trading. It had been down as many as 18 points earlier. The Nasdaq composite fell less than a point to 2,764.

Many analysts continue to believe a deal is all but inevitable. “It seems unlikely that Congress would choose financial Armageddon over some type of compromise,” said Joseph S. Tanious, a market strategist with J.P. Morgan Asset Management.

Some argue that the market’s recent downturn is overwhelming strong corporate earnings reports and other reasons to believe the economy will bounce back in the second half of the year.

“It’s definitely going to be a rocky couple of days,” said John Canally, an economist with LPL Financial. “It’s a very confusing time, but once this cloud lifts, market participants are going to turn around and say, ‘This isn’t so bad.'”

The government reported early Friday that economic growth slowed in the first half of the year to its weakest pace since the recession ended two years ago. Merck fell 2 percent even after the company reported strong earnings. Chevron also lost a fraction of a percent despite better second-quarter earnings.

Some stocks managed to rise despite the broad downturn. Housewares maker Newell Rubbermaid Inc. jumped 8 percent after reporting that its profit rose 13 percent as strong demand from emerging markets offset weakness in the U.S. Expedia Inc. gained 8 percent after the travel website operator said its income rose more than analysts had expected. It credited an increase in the number of travel bookings and higher prices for plane tickets and hotel rooms.

Some investors said that the economic report wasn’t as bad as it first appeared. Phil Orlando, chief strategist at Federated Investors, said that the report was a “rearview mirror view of an economy that was struggling with the impact of the earthquake in Japan and high commodity prices.” Orlando said he believes that rising corporate profits and a rebound in the auto industry will push stocks higher for the rest of the year.

Traders bought U.S. government bonds, pushing the yield on the benchmark 10-year Treasury note down to 2.84 percent from 2.95 percent late Thursday. As demand for bonds increases, the government is able to pay bondholders lower interest rates, causing yields to fall.

House Republicans are trying for the third straight day to pass a bill that would raise the borrowing limit while cutting federal spending by nearly $1 trillion. President Barack Obama said again Friday that he will not sign the Republican bill. Democrats say any bill must raise the debt ceiling enough to postpone any additional increases until at least 2013.