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In a statement, Moody's said it would put the Aaa U.S. credit rating on review for a possible downgrade if lawmakers in Washington do not make substantive progress in budget talks by the middle of July.

"Since the risk of continuing stalemate has grown, if progress in negotiations is not evident by the middle of July, such a rating action is likely," Moody's said.

The rating outlook is stable whereas Standard & Poor's in April revised to negative its credit outlook on the U.S. rating, citing similar concerns over political wrangling in Washington over what many consider are unsustainable levels of U.S. debt.

The heightened polarization over the debt limit has increased the chances of a short-lived default. If this situation remains unchanged in coming weeks, Moody's will place the rating under review, the firm said.

Without a debt limit increase, either on August 2 or some later date, U.S. Treasury Secretary Timothy Geithner likely would have to make decisions on which bills to pay. He could decide to delay Social Security benefit payments to retirees, withhold military pay, sell some government assets or not pay off government bond-holders.

The U.S. deficit is expected to reach $1.4 trillion this year. The debt ceiling is currently $14.3 trillion.

The ratings agency said if the debt limit is raised and default avoided, the Aaa rating will be maintained. Still, the rating outlook will depend on the outcome of the debt talks, Moody's said.

"Moody's downgrade adds pressure on Congressional leaders to work hard at reaching an agreement to increase the debt ceiling," said Kathy Lien, director of currency research at GFT Forex in New York.

If a downgrade were to occur, Moody's said it would put the U.S. credit in the Aa range.

A face-to-face meeting is a chance for Geithner to make the case that the debt-limit vote is needed to address spending that has already been incurred and that with financial markets already shaky, a failure to lift the ceiling could further unsettle investors and risk grave harm to the economy.

"I think there is some consternation in terms of how politicians are going to play out the debt ceiling between now and August 2," said Fred Dickson, chief market strategist at D.A. Davidson & Co in Lake Oswego, Oregon.

"We're in a period of above-average volatility, and I think this will probably add to that."

(Additional reporting by Nick Olivari; Editing by James Dalgleish)

The Economic and Financial Committee (EFC) of deputy ministers and senior officials of the 17-nation currency zone approved the Greek program in principle in talks in Vienna that ended after midnight, the source said.

The second program for Greece, which will effectively supersede the 110 billion euro ($160 billion) bailout agreed in May 2010, will involve some participation of private sector investors but limited to avoid triggering a credit event, the source said.

Details of that involvement, and the apportionment of the additional official international funding, remain to be worked out in time for a June 20 meeting of euro zone finance ministers, the source said.

He declined to comment on figures but said the program would cover Greece's funding needs on the assumption that it could not return to private capital markets in 2011 or 2012. The original bailout envisaged Athens raising 27 billion euros on the markets next year and 38 billion in 2012.

A troika of EU, European Central Bank and International Monetary Fund inspectors has been working with the Greek government for weeks on a detailed plan of additional spending cuts, revenue increases and privatizations to get Athens back on track after it missed fiscal targets due to a revenue shortfall.

The source said the program would involve detailed commitments by Greece on the governance of a new national wealth agency and the timing of specific privatizations, but it would stop short of intrusive international supervision of the agency.

(Reporting by Paul Taylor; editing by Dina Kyriakidou/Ruth Pitchford)

Initial claims for state unemployment benefits slipped 6,000 to a seasonally adjusted 422,000, the Labor Department said. The prior week's figure was revised up to 428,000.

Economists polled by Reuters had forecast claims dropping to 415,000 from a previously reported count of 424,000.

The claims report falls outside the survey period for the government's closely watched data on nonfarm payrolls for May.

The government is expected to report on Friday that employers added 150,000 jobs last month, according to a Reuters survey, after increasing payrolls by 244,000 in April.

Initial claims have been volatile in recent weeks as supply chain disruptions from the March earthquake in Japan caused temporary motor vehicle plant closures.

Claims have also been distorted by bad weather in some parts of the country and problems smoothing the data for seasonal variations.

A Labor Department official said there was nothing unusual in the state-level data, but noted that four states and territories, including Virginia and Oklahoma, had been estimated because of the Memorial Day holiday on Monday.

He also said Missouri had indicated that floods were affecting claims in the state, but provided insufficient information to quantify the impact.

The four-week moving average of new jobless claims, considered a better gauge of labor market trends, fell 14,000 to 425,500.

Initial claims have now been perched above the 400,000 mark for eight weeks in a row. Analysts normally associate that level with steady job growth.

The number of people still receiving benefits under regular state programs after an initial week of aid slipped 1,000 to 3.71 million in the week ended May 21.

Economists had expected so-called continuing claims to dip to 3.67 million from a previously reported 3.69 million.

The number of people on emergency unemployment benefits rose 3,363 to 3.42 million in the week ended May 14, the latest week for which data is available. A total of 7.68 million people were claiming unemployment benefits during that period under all programs.

(Reporting by Lucia Mutikani; Editing by Neil Stempleman)

Investors awaited U.S. weekly jobless claims, due at 8:30 a.m. EDT, factory orders at 10 a.m. EDT as well as chain store sales for last month. Sales from retailers are expected to show how higher gasoline prices have crimped consumer demand for summer clothing and other discretionary items.

The high unemployment rate means the Fed's ultra-easy money policies remain the right course of action, top Federal Reserve officials said on Wednesday. High unemployment is not a "quickly resolvable problem," but April's job gains show that the economic recovery is on a firmer footing, Cleveland Fed President Sandra Pianalto said.

The dollar stuck near a one-month low against a basket of currencies and hovered near a record low versus the Swiss franc on Thursday, after more weak U.S. data suggested that the U.S. economy's soft patch may become protracted.

Suspected Chinese hackers tried to steal the passwords of hundreds of Google (GOOG.O) email account holders, including those of senior U.S. government officials, Chinese activists and journalists, the Internet company said.

China's Foreign Ministry on Thursday said it "cannot accept" accusations that hackers likely based in China tried to break into hundreds of Google mail accounts.

Private equity firm Gores Group is in talks to buy more than half of bankrupt bookseller Borders Group Inc's (BGPIQ.PK) remaining stores, the Wall Street Journal reported on Wednesday, citing people familiar with the matter.

Starbucks Corp (SBUX.O) said it signed an agreement with its joint venture partner in South China, Maxim's Caterers Ltd that gives the world's largest coffee chain full control of more than half of its retail stores in mainland China.

Citigroup Inc (C.N) shut down a $400 million hedge fund that used the bank's money and mathematical models to bet on stocks, in the wake of new regulations aimed at stopping proprietary trading, Bloomberg reported, citing a person familiar with the matter.

Microsoft Corp (MSFT.O) showed off a version of its next operating system at technology conferences in the United States and Taipei, as some PC makers grumbled over restrictions on their involvement in the development of the system.

European stocks were down around 1 percent in morning trade, dropping for a second straight session, hit by the latest string of poor U.S. macro data and after Moody's cut Greece's credit rating by three notches. The credit rating agency cited a growing risk that the government will fail to stabilize its debt position without a debt restructuring.

Moody's downgrade has moved Greece's ratings to the extremely speculative level of "Caa1," seven notches into junk territory, from the previous level of B1.

Wall Street ended a four-day rally with its worst session since August on Wednesday and could suffer more losses in coming days as investors are faced with more signs the economic recovery is fading.

The Dow Jones industrial average .DJI was down 279.42 points, or 2.22 percent, at 12,290.37. The Standard & Poor's 500 Index .SPX was down 30.66 points, or 2.28 percent, at 1,314.54. The Nasdaq Composite Index .IXIC was down 66.11 points, or 2.33 percent, at 2,769.19.

(Reporting by Blaise Robinson. Editing by Jane Merriman)

Still, some chains are outperforming rivals with better merchandise and customer service, gaining market share and topping analysts' estimates.

U.S. chain stores are expected to show a 5.4 percent rise in May sales at stores open at least a year, according to Thomson Reuters data. That compares with gains of 8.9 percent in April, when sales were fueled by a late Easter holiday, and 2.6 percent in May 2010, when the economy was still fitful and many experts feared a double-dip recession.

"The consumer is still in slow recovery mode," said FBR Capital Markets analyst Liz Dunn. "They are being selective ... and really consolidating purchases around places where they feel like there is better fashion."

One stand-out, she said, is department store operator Macy's Inc (M.N), which reported a better-than-expected 7.4 percent rise in May sales at stores open at least a year on Wednesday. It also raised its sales target for the current quarter.

Teen apparel retailer Zumiez Inc (ZUMZ.O) also posted a better-than-expected 7.8 percent rise for May. Analysts were expecting 7.5 percent.

Hot Topic Inc (HOTT.O), another retail chain that targets teenagers, reported a smaller-than-expected 0.4 percent rise for May, but affirmed its second-quarter outlook.

BATTLE FOR MARKET SHARE

For Christa Hirneisen, who was shopping at a Gap store in midtown Manhattan on Wednesday, gas prices have tempered her spending, since she drives a lot.

"For the things I can hold off on for a bit, I won't buy," she said.

Since consumers are spending less, competition for their dollars has heated up, said Walter Stackow, senior research analyst for Manning & Napier Advisors, which invests in the retail sector.

"There's not really a rising tide," Stackow said. "For every winner there's going to be a loser."

Many retailers blamed cool, wet weather for disappointing results in April, and the conditions persisted into May, said weather tracking firm Planalytics. May began with the coolest run-up to Mother's Day since 2005, but then warmed up, it said. In addition, the country experienced over 350 tornadoes.

Another round of disappointing economic data on Wednesday showed that U.S. private employers added a scant 38,000 jobs in May, the lowest level since September 2010, while an index of national factory activity fell more than expected in May to its lowest level since September 2009. The Standard & Poor's 500 Index .SPX fell 2.3 percent.

(Additional reporting by Phil Wahba and Dhanya Skariachan in New York; editing by Andre Grenon)

Readings of economies around the world from China to the United States have been for the most part undershooting forecasts, raising questions about how well risky assets such as stocks and high yield bonds will hold up once the Federal Reserve's $600 billion bond buying program ends this month.

Even as big banks such as Citi and Goldman cut their payrolls growth forecasts though, the equity market sell off has been tame compared with previous bouts of so-called "risk aversion" in global markets.

Furthermore, valuations of global equities on the basis of 12-month earnings forecasts are already running below their long-term average and below where they were the last time a protracted period of risk reduction caused a rout in share prices more than a year ago.

Those factors may limit a further sell-off in equities based on fears of a U.S. economic soft patch.

Japan's Nikkei share average fell 1.7 percent .N225, a smaller decline compared with the 2.3 percent tumble in the S&P 500 U.S. stocks index .SPX overnight.

Political uncertainty also loomed over Tokyo and weighed on stocks, after Prime Minister Naoto Kan, who faced a no-confidence vote in parliament, said he would resign after getting a nuclear crisis and other disaster-related matters under control.

The MSCI index of Asia Pacific shares outside Japan was down 2.2 percent, with selling heaviest in the materials, financial and technology sectors. Utilities and telecommunications stocks -- traditionally segments of the market where investors stash their money in times of volatility -- outperformed.

EQUITY VALUATIONS BELOW AVERAGE

Japanese stocks are valued at one time their current book value, Thomson Reuters StarMine data showed, cheaper than Irish and Portuguese shares. However, the market cap of companies listed on the Tokyo Stock Exchange is the third-highest in the world.

"U.S. shares needed a correction of their recent steep gains. Japanese shares will be capped for now but cheap valuations will give the market support," said Ryota Sakagami, strategist at Nomura Securities in Tokyo.

The MSCI all-country world stocks index is running at a 12-months forward earnings multiple of 11.7 times, lower than the 12.4 times average of the past two years and below the 13.5 times valuation they had when the escalating European debt crisis triggered a selloff in risky assets in April/May of 2010, according to I/B/E/S data.

GREECE CONFUSION STALLS EURO GAINS

The euro's march above $1.44 on Wednesday was halted after Moody's cut its sovereign rating on Greece by three notches as Athens struggles to avert a debt default.

The single currency was trading at $1.4360 on Thursday, up 0.3 percent due mostly to the slipping U.S. dollar.

"Looking at the recent data I don't think anyone is really expecting Friday's U.S. employment data to be strong. Investors have already tried to price in possible low figures on Friday, selling the dollar," said Sumino Kamei, a senior currency analyst at the Bank of Tokyo-Mitsubishi UFJ in Tokyo.

The median forecast of U.S. payrolls growth in May in a Reuters poll was revised down to 150,000 from the prior forecast of 180,000 after a report on Wednesday reflected weak private sector employment activity.

The euro though risked backtracking further to its Monday low around $1.4250 if headlines on Greece suggest a new round of financing is in jeopardy.

At times contradicting headlines on prospects for Greece's near-term financing has made the euro zig zag, though hopes for Greece were kindled after European Central Bank Executive Board member Juergen Stark was quoted as saying the ECB might accept a rollover of Greek debt by private investors.

Elsewhere in currency markets, the Australia dollar edged up after stronger-than-expected Australian retail sales, though remained in a range carved out last month and later was unchanged on the day at $1.0615.

The Australian dollar is considered by market participants to be a weather vane of investor tolerance for risk because of its relatively high yield and close economic relationship with China.

U.S. 10-year Treasury futures were steady after hitting a high for the year on Wednesday.

A sudden spill in U.S. stocks sent investors scurrying to the liquidity of the U.S. government bond market and sent the benchmark cash 10-year yield below 3 percent.

The 10-year note was retracing some of its overnight climb in early Thursday trade, bringing the yield back up a bit to 2.97 percent. A mix of selling in shorter maturity paper by speculators and mutual funds and central bank buying of longer dated debt made the yield curve its flattest of the year on Wednesday, Royal Bank of Scotland strategists said in a note.