08/01/2011 07:44 EDT | Updated 10/01/2011 05:12 EDT

Early stock market rally on debt agreement fades after a slowdown in US manufacturing

NEW YORK, N.Y. - The debt deal rally lasted all of 30 minutes.

A weak manufacturing report squashed an early rally that pushed the Dow Jones industrial average up 139 points minutes after the stock market opened Monday. The Dow was down as many as 145 points after the Institute of Supply Management said at midmorning that U.S. manufacturing barely grew last month. The Dow recovered some of its losses in the afternoon and was down less than 20 points with half an hour of trading left.

Analysts had expected stronger manufacturing growth. It was the first major economic report for July and could raise doubts about the predictions of many economists that the U.S. economy will regain momentum in the second half of the year.

"This was a shock to the market," said Phil Orlando, chief strategist at Federated Investors. "It clearly offset the emotional strength that we saw in the open from this tentative budget compromise."

Many investors had expected the stock market to rally Monday because President Barack Obama and Congressional leaders announced the day before that they had agreed on a deal to raise the nation's borrowing limit ahead of Tuesday's deadline. Asian stock markets, which closed before the manufacturing report was released, rose broadly overnight following the deal breakthrough.

The Dow Jones industrial average was down 18 points, or 0.2 per cent, to 12,124 in afternoon trading. It is the seventh day of declines for the Dow.

The broader Standard and Poor's 500 index lost 6, or 0.5 per cent, to 1,286. The Nasdaq composite lost 16, or 0.6 per cent, to 2,740.

The S&P index traded below its 200-day moving average of 1,280. Many traders use moving averages as benchmarks for when to buy and sell. Orlando said the S&P could fall to 1,250 or lower over the next few days as investors begin to doubt the strength of the economy.

Health care stocks fell nearly 2 per cent, the most of the 10 company groups in the S&P 500 index. United HealthGroup Inc., Aetna Inc., and St. Jude Medical Inc. fell more than 3 per cent after the government said it plans to cut Medicare reimbursement rates 11 per cent.

Bond yields fell to the lowest level of the year as investors moved into safer assets. The yield on the 10-year Treasury note fell to 2.73 per cent from 2.80 per cent late Friday. Oil futures dropped 1 per cent to just below $95 a barrel.

The manufacturing report led to a worldwide pullback from riskier assets. The Euro Stoxx 50, an index that tracks blue chip companies in countries that use the euro, fell nearly 3 per cent. Oil futures dropped 1 per cent to just below $95 a barrel. And gold made up its early losses to remain near $1,630 an ounce.

The sell-off comes after other signs the economy has slowed. On Friday, the government said that so far this year the economy has grown at its slowest pace since the recession ended in June 2009. A debt deal that contains reductions in short-term government spending could further weaken the economy, analysts say.

The latest signs of weakness in the U.S. economy pushed the dollar lower against the Japanese yen and the Swiss franc, two currencies that traders see as relatively safe bets. The dollar touched another record low against the franc, and reached a post-World War II low against the yen.

Before the ISM report was released, stocks rose sharply largely because President Barack Obama and Congressional leaders announced Sunday that they had agreed on a deal to raise the nation's borrowing limit ahead of Tuesday's deadline. Investors have been worried that the U.S. might default if a deal wasn't reached. The federal government would be unable to pay all of its bills after Tuesday if a law is not signed. Among them: interest payments on Treasury bonds, salaries of federal employees and Social Security checks to retirees.

The debt agreement would raise the U.S. debt limit by $2.1 trillion. It would also cut at least $2.4 trillion in federal spending over 10 years. Under the bill, a new joint committee of Congress would recommend deficit reductions by the end of November that would be put to a vote by Congress by year's end.

The House is expected to vote on the measure Monday afternoon. Majority Leader Harry Reid said that he hopes that a vote will take place in the Senate as well.

The fact that Congress hadn't yet passed the bill and that many important details were to be decided by the new committee left some investors skeptical about its impact.

"The debt agreement was a step in the right direction but probably a small step," said Bob Gelfond, the head of MQS Asset Management, a hedge fund based in New York City.

Others remained concerned that the bill would cut the deficit enough to prevent a downgrade to the U.S. government's stellar credit rating. Credit ratings Standard and Poor's and Moody's declined to comment on the bill.