With the clock ticking towards the Aug. 2 deadline, markets believe a last-minute deal will be reached but the likelihood of a longer-term agreement looks increasingly unlikely.

Standard & Poor's has said there is at least a "one-in-two" chance it could cut the United States' longer-term credit rating if there is no credible longer-term plan to reduce the country's deficit, while Moody's has threatened a negative outlook.

Benchmark 10-year yields were half a basis point higher at 3.01 percent, up around 10 basis points since last Monday.

But implied volatility on Treasury futures is still at a historically subdued level, reflecting a relative calm in the market despite higher risk assets such as equities coming under pressure.

"People are so used to using the dollar, it being at the heart of everything, that they're unlikely to change what they do," said Lloyds Bank strategist Charles Diebel.

"But if bank funding costs rise or (a large fund) says they won't buy Treasuries anymore then you could see a significant spike in yields."

Treasuries pared earlier losses, as Bunds rallied in the wake of T-bill auctions from Spain and Italy that failed to reassure markets that a second Greek rescue package agreed last week would stop the spread of the euro zone debt crisis.

President Barack Obama, in a televised address aimed at rallying public support for a package proposed by Democrats, warned that failure to increase the US borrowing limit would have severe economic consequences.

But his speech gave no sign of whether Democrats and Republicans were making progress to seal an agreement.

"It looks like there is a serious ideological confrontation, making us wonder whether compromise is possible," said a trader at a Japanese bank.

House Speaker John Boehner, the top Republican in Congress, advanced a two-stage deficit-reduction plan that would start with an initial $1.2 trillion in savings over 10 years, placating demand from Tea Party conservatives who do not want any tax hike to be included in the deal.

Democrats formally presented their competing plan for $2.7 trillion in deficit reduction over the next decade, which Boehner dismissed as "full of gimmicks."

Diebel said that with central banks holding trillions of dollars of US debt, they were unlikely to start selling in the event of a credit rating downgrade as that would push yields up on the remaining paper they held.

But he said money market funds -- which have to hold triple-A rated paper -- could be the weak point.

"Money market funds are the biggest fragility," he said.

"They have to hold triple-A paper and that could cause some significant dislocations and could start affecting the funding costs of banks."

Analysts said macro hedge funds and others were reluctant to trade, having struggled with choppy markets all year, and cut back on positions heading into the European summit on Greece last week.

"It has been a tough year for macro funds, and many do not want to trade Washington headlines," said Alan Ruskin, macro strategist at Deustche Bank in New York.

Copyright Reuters, 2011