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The deficit reduction debate is coming up against an August 2 deadline when the $14.3 trillion limit on America's borrowing capacity is exhausted, putting in jeopardy payments on U.S. Treasury debt as well as paychecks for federal employees and soldiers.

If an agreement is reached to raise the debt ceiling but nothing meaningful is done in terms of deficit reduction, the U.S. would likely have its rating cut to the AA category, S&P said.

"While banks and broker-dealers wouldn't likely suffer any immediate ratings downgrades, we would downgrade the debt of Fannie Mae, Freddie Mac, the 'AAA' rated Federal Home Loan Banks, and the 'AAA' rated Federal Farm Credit System Banks to correspond with the U.S. sovereign rating," S&P said in its report.

"We would also lower the ratings on 'AAA' rated U.S. insurance groups, as per our criteria that correlates insurers' and sovereigns' ratings," the firm said.

However, S&P said it sees a failure to reach an agreement on raising the debt ceiling and reducing deficits as the least likely scenario, adding that in such a case the global financial markets would be in turmoil and "likely shove the U.S. economy back into recession."

In such a hypothetical case, it envisages the U.S. Treasury curtailing spending sharply and the U.S. Federal Reserve launching another round of quantitative easing to help prop up the economy.

"Under this scenario, we expect that interest rates could rise--say, 50 bps on short-term rates and double that on the long end--though this may depend on whether Treasuries would lose their status as the safe haven that investors have historically perceived them to be, or whether physical assets such as gold would benefit from such a flight to quality," S&P said.

It added that either way, corporate borrowers would likely see yield spreads widen while equity markets and the U.S. dollar would likely suffer.

The outline of potential knock-on effects of a U.S. credit rating downgrade were first reported by Market News International.

As Aug 2 approaches, the U.S. Treasury market has grown sensitive to news on the potential for the U.S. to actually default or, even if Washington can reach a deal to avoid default, a downgrade based on longer-term fiscal conditions.

The S&P's latest comments led to selling in longer-dated Treasuries, with the 30-year bond briefly falling a full point in price.

(Reporting by Emily Flitter and Daniel Bases; Editing by Theodore d'Afflisio)

Initial claims for state unemployment benefits increased 10,000 to a seasonally adjusted 418,000, the Labor Department said.

Economists polled by Reuters had forecast claims rising to 410,000. The prior week's figure was revised up to 408,000 from the previously reported 405,000.

The claims data covered the survey period for the closely watched nonfarm payrolls count for July. Initial claims dropped 11,000 between the June and July survey periods, suggesting a modest improvement in payrolls after June's paltry 18,000 gain.

A rise in layoffs held back payroll growth in May, according to the department's latest Job Openings and Labor Turnover Survey, which was released last week. Layoffs were probably behind the downshift in employment growth in June as well.

A government shutdown in Minnesota following a budget impasse resulted in an additional 1,750 state employees filing claims for jobless benefits last week.

Initial claims have now been above the 400,000 mark for 15 straight weeks. That level is usually associated with a stable labor market.

The four-week moving average of claims, considered a better measure of labor market trends, slipped 2,750 to 421,250.

The number of people still receiving benefits under regular state programs after an initial week of aid dropped 50,000 to 3.70 million in the week ended July 9.

The number of Americans on emergency unemployment benefits declined 80,133 to 3.15 million in the week ended July 2, the latest week for which data is available.

A total of 7.33 million people were claiming unemployment benefits during that period under all programs, down 159,000 from the prior week. (Reporting by Lucia Mutikani; Editing by Neil Stempleman)

Intel Corp (INTC.O) trimmed its forecast for 2011 personal computer unit sales, warning of softness in mature markets and sending its shares down more than 1 percent even as its revenue outlook beat estimates. The shares traded in Frankfurt (INTC.F) were down 2.8 percent.

American Express Co (AXP.N) posted a 31 percent increase in second-quarter profits, beating analysts' expectations, as customers spent more on their cards and the company's processing revenue jumped. The shares traded in Frankfurt (AXP.F) were down 0.1 percent.

European stocks were down 0.6 percent in morning trade, led lower by tech stocks as investors ditched shares in mobile phone network equipment supplier Ericsson (ERICb.ST) after it missed earnings forecasts, due to a hefty jobs cut charge, and forecast less profitable business in the pipeline in Europe.

Investors awaited the emergency euro zone summit in Brussels on Thursday to see if a new bailout deal can be forged for debt-stricken Greece. After seven hours of talks late into Wednesday night between German Chancellor Angela Merkel and French President Nicolas Sarkozy in Berlin, the two leaders reached a common position on a second rescue package for Greece, that will be presented to the meeting. Details of the common position were not revealed.

A buyback of Greek debt is the only form of private sector involvement in the second bailout that has a chance of not triggering a downgrade of Greek sovereign debt to a 'selective default', a euro zone source said. Euro zone sources close to talks on Thursday on the second bailout said the buyback idea was one of the main options now under consideration.

On the earnings front, investors awaited results from companies including Morgan Stanley (MS.N), Advanced Micro Devices Inc (AMD.N), Eli Lilly (LLY.N), Microsoft Corp (MSFT.O), Pepsico Inc (PEP.N) and AT&T (T.N).

On the macro side, the market awaited weekly jobless claims, as well as leading indicators.

Data showed on Thursday Chinese manufacturing contracted for the first time in a year in July and at its fastest pace since March 2009, as the country's monetary policy tightening and sluggish global demand weighed on the economy.

U.S. stocks closed near unchanged on Wednesday, a day after Wall Street's best rally since March, as the oncoming debt ceiling deadline overshadowed strong earnings from Apple Inc.

The Dow Jones industrial average lost 15.51 points, or 0.12 percent, at 12,571.91. The S&P 500 Index shed 0.89 points, or 0.07 percent, at 1,325.84. The Nasdaq Composite Index fell 12.29 points, or 0.43 percent, at 2,814.23.

(Reporting by Blaise Robinson; Editing by Greg Mahlich)