NEW YORK: Wall Street strategists are warning that the return of divided government could disrupt the bond market next year by setting the stage for a bruising fight over the debt ceiling.
“The single biggest source of domestic policy uncertainty remaining in the United States is the debt ceiling that will become binding by second quarter of next year (2Q27),” said George Saravelos, strategist at Deutsche Bank.
The United States is about US$800bil shy of its US$41.1 trillion borrowing limit, and strategists expect the government to hit that ceiling sometime in the first half of the year.
The Treasury department can avoid breaching the limit by deploying extraordinary accounting measures to create borrowing room.
But Congress will eventually need to raise or suspend the limit to avoid the risk of a default.
The Democratic sweep of Congress raises the prospect of a prolonged confrontation with President Donald Trump over the government’s borrowing.
Fitch Ratings warned last month that Democratic control of Congress could increase the likelihood of brinkmanship over the debt ceiling.
The ratings agency said the outgoing Republican-led Congress could raise or suspend the debt ceiling before its term expires at year’s end, but if it doesn’t, the issue could become a major test of the new Congress.
A stand-off next year could disrupt parts of the curve.
During past confrontations, investors have sold Treasury bills maturing around the date the government was projected to run out of money, while buying securities maturing before or after the so-called X-date, creating a kink in the curve.
“If Congress fails to address the debt ceiling issue before year-end, financial markets could face a protracted debt ceiling standoff in 2027,” said Vail Hartman, strategist at BMO Capital Markets.
Such an outcome would reflect Democrats making “the debt ceiling a powerful source of leverage for the party to extract concessions from the Trump Administration”, next year and likely result in Treasury bill “price distortions around the projected X-date, and increased volatility in cash and repo markets”.
Right now, the T-bill curve shows little sign of concern, with the government still months away from hitting the limit. But that could change.
CIBC strategists led by Michael Cloherty said on Wednesday that investors should “have more risk premium priced” for the money market into 2027.
Investors have historically welcomed divided government in Washington because it creates policy gridlock and restrains spending. In keeping with that trend, Treasuries rallied across the curve on Wednesday as the results form the mid-terms revealed a much larger-than-expected win for Democrats.
Since the mid-1990s, split government has often been a bullish recipe for treasuries. Benchmark 10-year yields have been lower on average one and 12 months after midterms that produced such a result, Bloomberg-compiled data show.
But with the US deficit at roughly 6% of the economy and publicly held debt of more than US$32 trillion – excluding money the government owes to programmes like Medicare and Social Security – and with both the Trump Administration and an incoming Democratic congress promising new spending “that assumption deserves re-examination”, said George Brown, senior economist at Schroders.
“If political compromise increasingly means larger deficits rather than fiscal consolidation, investors may demand a higher term premium to hold long-dated Treasuries.”
That could lead to a steeper yield curve, he said.
Past debt ceiling showdowns have raised the prospect of Treasury not paying interest on some of their outstanding bills when they mature, sparking fears of a “technical default” and these episodes of US government dysfunction has also compelled rating agencies to act.
Fitch Ratings downgraded the United States in August 2023 by one level to AA+, citing concerns about political wrangling over the debt ceiling that took the nation to the brink of a default.
CIBC’s Cloherty said he also expects the Republicans to try to raise the borrowing limit before they leave Congress during their lame-duck session, but predicted the effort will fail.
That will leave a new Congress facing what CIBC said will be “intense debt ceiling battles in 4Q27 and beyond”. — Bloomberg
