Wall Street strategists warn that the return of divided government could disrupt the bond market next year by setting up a bruising fight over the debt ceiling. George Saravelos, strategist at Deutsche Bank, said, "The single biggest source of domestic policy uncertainty remaining in the US is the debt ceiling that will become binding by Q2 of next year." The US is about $800 billion shy of its $41.1 trillion borrowing limit, and strategists expect the government to hit that ceiling in the first half of the year. The Treasury can avoid breaching the limit by deploying extraordinary accounting measures, but Congress will eventually need to raise or suspend the limit to avoid the risk of default.
The Democratic sweep of Congress raises the prospect of a prolonged confrontation with President Donald Trump over government borrowing. Fitch Ratings warned last month that Democratic control of Congress could increase the likelihood of brinkmanship. A standoff could disrupt parts of the yield curve. In past confrontations, investors have sold Treasury bills maturing around the projected date the government would run out of money, creating a kink in the curve. Right now the T-bill curve shows little sign of concern, but CIBC strategists led by Michael Cloherty said investors should "have more risk premium priced" for the money market into 2027.
Investors have historically welcomed divided government because it creates policy gridlock and restrains spending. Treasuries rallied across the curve after midterm results revealed a much larger-than-expected win for Democrats. However, with the US deficit at roughly 6% of the economy and publicly held debt above $32 trillion, George Brown, senior economist at Schroders, said the assumption that gridlock restrains spending "deserves re-examination." He noted that if compromise means larger deficits, investors may demand a higher term premium, which could steepen the yield curve.
Past debt ceiling showdowns have raised fears of a "technical default" and prompted rating agencies to act. Fitch downgraded the US in August 2023 to AA+, citing political wrangling over the debt ceiling. CIBC's Cloherty expects Republicans to try to raise the borrowing limit during their lame-duck session, but predicts the effort will fail, leaving a new Congress facing what CIBC calls "intense debt ceiling battles in Q4 27 and beyond."
Source: Bloomberg Markets · Summarized by HeadlinesBriefing