Default cloud hangs over U.S. job market

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - The terrifying prospect of a U.S. debt default has left a cloud over businesses already reeling from the economy's tepid performance, and likely left them reluctant to ramp up hiring in July.

A heated political battle over how to raise the nation's debt ceiling has helped make the once-distant prospect of a downgrade of the U.S. AAA credit rating a strong possibility. Even worse, investors are grappling with the unthinkable: an outright default on U.S. government debt.

The fight over the debt, which started with a refusal by some Republicans to lift the largely procedural debt limit without sharp cuts in government spending, comes with the U.S. economy already struggling to remain above water.

Data on second-quarter gross domestic product published on Friday showed the world's largest economy expanded at just a 1.3 percent annual rate in the April to June period. More worrying, revisions to the first quarter left annualized GDP at a 0.4 percent pace -- perilously close to a contraction.

The figures prompted some analysts to wonder whether market forecasts for an unspectacular gain of 90,000 jobs in July may be overly optimistic, following truly dismal readings for May and June. The jobs report is due on Friday.

"It certainly tempers my outlook, resets expectations," said Jason Ware, senior research analyst at Albion Financial Group in Salt Lake City. "If we're going to have any type of material uptick in private-sector employment, we're going to be growing faster than 1.5 percent."

The furor over the U.S. debt crisis has temporarily diverted attention from Europe's troubles, which continue to simmer nonetheless. Moody's Investors Service said on Friday it had placed Spain's ratings on review for a possible downgrade, citing funding pressure and a precedent set by the euro zone's debt package for Greece.

That rescue deal was supposed to calm contagion fears but does not appear to have done the trick. Borrowing costs for Italy, for instance, soared at the country's latest bond auction.

Austerity measures appear to be taking a toll on many of the economies they were meant to help, and a report on euro zone unemployment is expected to show a steady 9.9 percent jobless rate for the monetary union.

D-DAY AND THE R-WORD

Still, investors will continue to focus their attention on the more immediate and potentially catastrophic risk -- a non-resolution of the U.S. debt debacle that leads to a crippling government shutdown or even a debt default.

Most investors say the latter scenario remains highly unlikely since the government should have enough revenues to continue making bond payments for some time, particularly if it gives top priority to bond holders as expected.

But that doesn't mean recession risks are not rising.

"We continue to think that the federal government will be able to avoid a default, but will probably still lose its AAA credit rating," said Julian Jessop, economist at Capital Economics. "Default might also only be averted at the cost of a shutdown of non-essential government services that could tip the U.S. economy into recession."

A tense calm over the debt standoff has permeated the U.S. Treasury bond market, which continued to rally in the latest week, pushing 10-year yields to 2.80 percent, their lowest level since November.

Before Friday's U.S. employment number, economists will eye two other key indicators: the Institute for Supply Management's factory survey and the ADP employment report, which is used as a rough guide to the government's broader gauge.

The ISM index is seen easing somewhat, to 54.9 from 55.3, according to a Reuters poll. On ADP, economists are looking for a gain of about 100,000 new private-sector jobs -- in keeping with their overall payrolls forecasts.

Officials at the U.S. Federal Reserve have continued to indicate a high reluctance to embark on any new program for monetary easing. But if the job market enters another rut, the pressure for renewed action could mount. <FED/FOCUS> The Fed next meets to set policy on August 9.

(Reporting by Pedro Nicolaci da Costa; Editing by Dan Grebler)