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The market pared losses late in the day before Congress was expected to vote on Monday on a debt deal backed by the White House, which includes spending cuts of $2.4 trillion over 10 years.

The deadline for a deal, which includes raising the U.S. borrowing limit, is Tuesday at midnight.

"It's an on-again, off-again market, and it reflects the on-again, off-again nature of these debt ceiling deliberations," said Hugh Johnson, chief investment officer of Hugh Johnson Advisors LLC in Albany, New York.

"Investors now believe that the debt limit will be raised, that the vote will be positive in the Senate and positive in the House, but there's still a bit of skepticism or caution."

Stocks fell after the Institute for Supply Management said the U.S. manufacturing sector grew at the slowest pace in two years in July. The ISM report followed similarly weak reports from much of Asia and Europe.

The defense and health care sectors, which would be subject to U.S. budget cuts if a deal is not reached, were among the hardest hit. The iShares Dow Jones US aerospace and defense exchange traded fund fell 1.1 percent while S&P's healthcare index lost 1.7 percent.

Healthcare stocks also fell after the Centers for Medicare & Medicaid Services said Friday that it will cut payments to skilled nursing facilities by 11 percent. Kindred Healthcare fell 30 percent and Skilled Healthcare lost more than 43 percent.

The Dow Jones industrial average dropped 10.75 points, or 0.09 percent, to 12,132.49. The Standard & Poor's 500 Index fell 5.34 points, or 0.41 percent, to 1,286.94. The Nasdaq Composite Index lost 11.77 points, or 0.43 percent, to 2,744.61.

"Today's trading has exposed the market. It apparently was hiding behind the 'debt ceiling' curtain, but now that that has been pulled back, we find that there are other problems -- namely, the economy," said Larry McMillan, president of McMillan Analysis Corp.

The S&P 500 rallied back above its 200-day after dipping sharply below that. The level has acted as strong support over the last two months and the fact that S&P 500 was able to rally back above it was a comfort to investors.

"The S&P which sliced through the 200-day moving average at 1,285, has taken that back in the last half hour (of trading)," said Elliot Spar, market strategist at Stifel, Nicolaus & Co in Shrewsbury, New Jersey, noting that as a sign of underlying resilience.

Stocks traded in a wide range. A rally in equity markets that began in Asia last night on optimism over a debt agreement eroded as the outcome seemed to struggle throughout Monday to bring the deal to a close.

If lawmakers approve the debt deal before the Tuesday deadline, it may end months of debate over whether the United States can avoid a debt default.

Even though a default was considered unlikely by many investors, the threat of a credit rating downgrade continued to weigh on sentiment after Wall Street marked its worst week in a year last week.

Shares of United Health slid 3.2 percent to $48.02 while Humana Inc dropped 3 percent to $72.36, despite Humana reporting a higher-than-expected second-quarter profit.

Among other health-care stocks, shares of Pfizer shed 1.2 percent at $19.01.

Some 8.3 billion shares changed hands on the New York Stock Exchange, NYSE Amex and Nasdaq, above the daily average of around 7.48 billion.

Advancers outweighed decliners on the NYSE by about 9 to 8, while on Nasdaq losers outpaced winners by about 5 to 4.

(Reporting by Edward Krudy; Additional reporting by Caroline Valetkevitch; Editing by Kenneth Barry)

The Institute for Supply Management said on Monday its index of national factory activity fell to 50.9, the lowest level since July 2009, from 55.3 in June.

Economists had expected a reading of 54.9. A reading below 50 indicates contraction in manufacturing.

The economy almost ground to a halt in the first half of the year, government data showed on Friday, with output rising at a tepid a 1.3 percent annual pace in the second quarter after advancing just 0.4 percent in the prior period.

The ISM report suggested the much anticipated bounce back in growth in the second quarter would probably be feeble.

"These are the types of numbers that are consistent with what we saw with the GDP numbers," said Keith Hembre, chief economist at Nuveen Asset Management in Minneapolis.

"Absent a governmental shock, we would dredge forward with this stagnant economic performance. We'll be mired in this 1 to 2 percent (growth) environment we have been in."

Congressional leaders were scrambling to line up Republican and Democratic votes for a White House House-backed deal to raise the U.S. borrowing limit and avert a debt default.

The deal, which raises the $14.3 trillion debt ceiling and cuts about $2.4 trillion from the deficit over the next decade, was hammered out on Sunday.

Stock indexes turned negative after the factory data while bond prices rose. The dollar fell against the yen and the Swiss franc, but rose against the euro.

Manufacturing, which accounts for about 12 percent of gross domestic product, has shouldered the weak recovery from the 2007-09 recession.

Activity last month was held back by weak new orders, whose index fell to 49.2 from -- the lowest in two years, from 51.6 in June. Prices paid index fell to 59 from 68, while the employment index fell to 53.5 from 59.9.

Nonfarm jobs likely rose 85,000 in July, according to a Reuters survey, after June's paltry 18,000 gain. The Labor Department will release its monthly jobs data on Friday.

A separate report from the Commerce Department showed construction spending advanced 0.2 percent to an annual rate of $772.32 billion, the Commerce Department said. May's construction spending was revised to a 0.3 percent increase rather than the previously reported 0.6 percent decline.

Economists had expected construction spending to be flat in June. Overall construction spending fell 4.7 percent from a year ago.

Private construction spending rose 0.8 percent to a seven-month high as an increase in nonresidential outlays offset a second straight month of declines in spending on residential projects.

Spending on public construction projects dropped 0.7 percent to $278.91 billion, the lowest level since March 2007. The decline reflected weak spending on federal projects, which dropped 2.2 percent. State and local government spending fell 0.6 percent to the lowest level since November 2006.

(Reporting by Lucia Mutikani; Editing by Neil Stempleman)

At 0939 GMT, futures for the S&P 500, the Dow Jones and the Nasdaq 100 were up 0.9 to 1 percent, after U.S. stocks had ended the worst week in a year on Friday on a stalemate in debt talks. Analysts said the oversold conditions had also primed the market for a bounce.

The lawmakers were expected to vote on Monday on the White House-backed agreement. The Democratic-led Senate may pass the deal, but it may face tougher opposition in the House of Representatives where both conservative Tea Party supporters and liberal lawmakers have criticized it.

The dollar received a lift against the yen and Swiss franc as the debt deal prompted traders to unwind safe haven plays. Gold, which generally gains in difficult economic and political situations and had hit record highs last month, fell more than 1 percent.

"This morning's bounce is a classic relief rally, but investors remain concerned about the U.S. because they went so close to the wire in a game of what looked increasingly like reckless political brinkmanship," said Darren Sinden, senior sales trader at Silverwind Securities in London.

"And if the U.S. were to be downgraded, then higher borrowing costs would be a further obstacle to a continued recovery."

Rating agencies have said the United States could face downgrades to its gold-plated AAA sovereign debt rating, if the world's biggest economy failed to agree on a viable long-term deficit reduction program.

"Even if the debt ceiling is raised, all of the heavy lifting will be in front of us," said Peter Kenny, managing director in institutional sales at Knight Capital Group in Jersey City, New Jersey.

"I think it's an almost foregone conclusion that there is going to be a downgrade at some point."

Some analysts said any relief rally could be short-lived, with other big risks present. A report on Friday showed U.S. economic growth in the first half was much slower than anticipated.

Investors will continue to focus on company earnings and macroeconomic indicators. Both July ISM data and June construction spending numbers are due at 1400 GMT, while widely-watched non-farm payrolls data for July will be released on Friday.

Allstate (ALL.N), the largest publicly traded U.S. home and auto insurer, will report second-quarter results, having already warned of one of the worst quarters in its history because of U.S. tornado losses.

Other companies announcing results on Monday included health insurer Humana (HUM.N) and Vornado (VNO.N), whose core business focuses on U.S. office and retail properties.

Resource-related stocks were expected to be in demand as key base metals prices jumped and crude oil prices climbed more than 1.4 percent.

In Europe, the FTSEurofirst 300 index .FTEU3 of top shares rose 0.6 percent, while In Asia, Japan's Nikkei average .N225 surged 1.3 percent.

(Editing by Jane Merriman)

There remained a widespread assumption, however, that credit ratings agencies could downgrade U.S. Treasuries from their vaunted triple-A status, a move that would impact the valuation of numerous other assets.

After a tense weekend spent in search of a compromise to allow the U.S. borrowing limit to be lifted, U.S. President Barack Obama said leaders from both parties reached a deal to cut the budget deficit by $1 trillion over 10 years, with additional savings of $1.4 trillion possible.

The plan must be passed by both houses of Congress and will still face some opposition. But it is expected to allow the debt ceiling to be raised, avoiding the prospect of Washington not being able to pay its bills and defaulting.

World stocks as measured by MSCI .MIWD00000PUS climbed 0.6 percent with emerging market shares .MSCIEF up 1.2 percent.

There were large gains in Japan, where the Nikkei .N225 rose 1.3 percent. In Europe, the FTSEurofirst 300 .FTEU3 rose 0.7 percent with banking shares enjoying a big boost.

But there remained a degree of skepticism about how long the rise in risk sentiment would last, given the likely U.S. downgrade, which some believed could come this week.

"It is a relief rally on the back of the parties coming together, but it could only last for a couple of days as the United States could now face a ratings downgrade," Manoj Ladwa, senior trader at ETX Capital, said.

"That would impact every part of the United States."

It would also raise issues for assets elsewhere. Some large pension funds, for example, will only hold triple-A debt, meaning they may have to sell Treasuries and buy elsewhere, crowding trades into German Bunds, for example.

The relative valuations of a number of assets, meanwhile, are based on their difference from supposedly risk-free Treasuries.

UNWINDING

The flip side of Monday's stock rally was the unwinding of investors positions taken to protect against U.S. default.

Gold fell more than 1 percent before recovering slightly. It was at $1,614 an ounce after hitting all-time nominal highs last week.

The dollar rose against the Swiss franc, which has seen intense interest from investors as the dual euro zone and U.S. debt crises have stirred markets this year.

Commodity currencies -- those tied to the prospect of large developing market growth -- climbed, with the Australian dollar nearing a 29-year peak against the greenback hit last week.

"In the short term, there will be relief in market sentiment today and maybe this week, as the U.S. will avoid a default, but the problems are not fully solved so I think we will see a muted reaction," said Richard Falkenhall, currency strategist at SEB in Stockholm.

"You have the risk of ratings agency downgrades, and no further fiscal stimulus in this deal," he said.

On bond markets, yields on U.S. Treasuries and core euro zone debt rose, reflecting some selling to release money parked in fixed income in the runup to the U.S. deal.

The premium investors demand to hold Italian and Spanish government bonds rather than benchmark German Bunds fell in line with the outperformance of riskier assets.

(Additional reporting by Naomi Tajitsu and Joanne Frearson; Editing by John Stonestreet)