Shares rally on hopes of US debt deal

Australian stocks joined a worldwide rally on financial markets as hopes grew that US political leaders were moving closer to resolving a budget deadlock and averting an unprecedented debt default.

Asian markets rallied across the board by more than 1 per cent as US President Barack Obama and Republican leaders met for the first time in an effort to resolve the fiscal stalemate, which has resulted in the US government being shut down for more than a week.

A possible deal could result in a short-term extension of the US debt limit as negotiations over the budget continue.

The benchmark S&P/ASX200 closed about 1.6 per cent higher at 5230.9 points on Friday, one of its best-performing days in months. The broader All Ordinaries rose 1.6 per cent to close at 5228.8. South Korea's KOSPI closed 1.2 per cent higher and Japan's Nikkei 225 ended Friday 1.5 per cent higher.

The rally, which was expected to be continued by European markets, came after a week of nervousness among investors as an October 17 deadline for the raising of the US debt ceiling loomed.

Analysts, however, said the negotiations were still at an early stage and it was not yet clear when or how the political differences would be bridged.

"What's happened is the politicians realise that [the debt ceiling deadline is] less than a week away now ... and they are starting to behave more constructively," JP Morgan chief economist Stephen Walters said. "But remember, we don't have a deal yet."

Economists have warned that the US government shutdown, which is due to enter its second week, was having a direct impact on local economic activity and could also drag on other economies.

"The longer it takes to reach a resolution to the impasse, the bigger the drag on growth, and the harder it will be to accurately gauge the state of the economy," ANZ economists said.

Global markets have not yet moved into a full panic over a potential default, with most analysts tipping a compromise before Thursday's deadline.

In recent days, however, investors have been positioning for the possibility the government might delay some payments on short-term government debt in the days after hitting the debt ceiling.

Money market funds and banks, in turn, were dumping short-term government debt, known as Treasury bills, set to come due in October and November.

At the same time, the price for credit default swaps used to insure investors against volatility in US government debt have started to move higher in recent days.

The lack of a political resolution has already affected confidence levels in the US. Americans have become more pessimistic, according to IBD/TIPP and Gallup measures of confidence.

"This is sowing the seeds for a much more material real activity impact," Westpac economist Elliot Clarke said. "With household consumption growth soft and the housing market under pressure from higher rates, the deterioration in confidence is a very unwelcome development."

Mr Walters said a US default would profoundly impact financial markets as the US dollar remained the world's reserve currency.

"The bonds of the world's reserve currency are in default, that has very serious implications for the rest of the world," Mr Walters said of a possible default by the US on its debt obligations. "We can't really work out what would happen on financial markets because I don't think anyone really thinks that's going to happen. The impact is just too ugly to contemplate."