NEW YORK (CNNMoney.com) -- Sluggish stock trading and a slowdown in merger activity are expected to take a bite out of third-quarter earnings at some of the nation's top investment banks.

Earnings season is just around the corner for major players like Goldman Sachs (Charts), Lehman Brothers (Charts) and Bear Stearns (Charts), which are all slated to report their fiscal third-quarter results next week. But Wall Street is already bracing itself for some disappointments with analysts slashing estimates for some of the banks.

And some on Wall Street expect that whatever positive sentiment investors had for the sector could fizzle, sending the firm's stocks sharply lower.

While there's little surprise that the industry is experiencing some slowdown in the summer months (they're not called the summer doldrums for nothing), analysts fear that the latest quarter could start a prolonged downturn in earnings for the banks after an unusually strong period of equity underwriting and growth in the capital markets.

Rising interest rates, in particular, threaten the banking industry. Banks and securities firms borrow money at short-term rates and lend at long-term rates. So rising short-term rates tend to squeeze their profits.

"I think what you're going to see is the cracks in the facade begin to appear," said David Easthope, analyst with the securities and investment group at independent research and consulting group Celent. "There's no way these near-perfect conditions in the market can continue."

Most notably, Goldman, Lehman, Bear Stearns and Morgan Stanley (Charts) - which will post its third quarter earnings on Sept. 20 - benefited from strength in mergers and initial stock offerings that boosted fees for the companies.

But according to data from M&A tracking firm Dealogic, M&A volume fell in the third quarter. Goldman Sachs, long the leader in the global merger advisory business, saw deal volumes tumble to $77.2 billion in the quarter from $271.7 billion in the second quarter. That pushed the company out of the top five in terms of advisory rankings.

Lehman Brothers didn't even make the top 10, with volume sinking 71 percent to $32.5 billion from the second quarter. Morgan Stanley's global M&A deal volume dropped to $115.5 billion from $195.1 billion and Bear Stearns saw volume tumble to $2.9 billion from $29.4 billion.

"Rates are going up and that makes M&A activity and IPO offerings less likely to happen," Easthope said. "The capital windows are starting to close."

And that's causing analysts to reign in some of their enthusiasm for the investment brokerage stocks.

Dick Bove, analyst at Punk, Ziegel & Co., recently cut the sector to market perform from his previous buy rating, citing a litany of near-term negatives such as the drop in IPO offerings, reduced trading activity, weakening mortgage markets, slower asset growth and lower private equity profits to name a few.

And Bove, a self-proclaimed bear on the markets prospects into 2007, warned that investment banks may continue to take a hit into next year if the U.S. economy falls into a recession, propelled in part by further weakness in the housing market, which could deplete consumer spending power.

Not all analysts were as pessimistic as Bove, however.

Fox-Pitt Kelton analyst David Trone lowered his second half 2006 estimates for Lehman Brothers and Bear Stearns by 5 percent and cut Morgan Stanley and Goldman Sachs' third-quarter forecasts but left fourth-quarter estimates unchanged.

Still, Trone said despite some sluggishness in the third quarter, he expects the major players to rebound in the fourth quarter. Trone remained largely bullish that investment banking revenues for the biggest banks will keep growing in the fourth quarter.

Trone cut his third quarter forecasts for Goldman to $3.19 from $3.65 a share on a big drop in equity trading. A consensus of analysts expect the company to report third quarter earnings of $3 a share, according to earnings tracker Thomson First Call.

He also reduced third quarter views on Morgan Stanley to $1.41 from $1.46, citing a drop in trading and a tougher credit environment which could hit its Discover Card unit's revenue. But he said the company, under CEO John Mack's leadership, could provide the best earnings report of the third quarter.

Analysts expect Morgan Stanley to earning $1.37 a share in the third quarter, according to Thomson First Call.

But given the expectations that the sector faces some bumps ahead, should investors bail out now?

While all four firms due to report in coming weeks have fallen from their 52-week highs, investors have largely been giving the industry the benefit of the doubt despite the black cloud of rising rates.

Year-to-date, Goldman shares are up about 1 percent while Morgan Stanley clearly outperformed the group with an 18 percent gain and Bear Stearns shares climbed 12 percent. Lehman Brothers, however, lagged its peers, with its stock down almost 1 percent.

But analysts say it may be best for investors to be cautious about the industry in the near term, especially given the prospects for more weakness in the months ahead.

"It is becoming increasingly difficult to understand why these stocks should sell at higher prices from now than they are selling at today," Bove said in a research note.

And Trone, although fairly positive on the sector's prospects, said all of the companies - with the exception of Lehman, which he called undervalued - shouldn't excite investors enough to engage in aggressive buying.

-------------------------------------------------------------------------

• Big 3 banks look inward for growth
• Morgan Stanley to buy Glenborough REIT
• Financial stock sector