Debt Ceiling Drama! How the Bond Market Reacts and What It Means for Rates

Rates Spark: Debt ceiling deal adds to bond angst

A deal to raise the US debt ceiling increases selling pressure on Treasuries, but will also result in tighter financial conditions for the economy. This opens upside to EUR rates but a soggy economic backdrop means wider rate differentials near-term.

 

Once approved, the debt limit deal paves the way to a liquid crunch 

The deal between President Biden and House leader McCarthy amounts to the removal of a tail risk for financial markets, that of a US default. Even if this was a tiny probability event to begin with, it'll allow markets to focus on the more important debate: whether the Fed is indeed done with its hiking cycle. The budget deal, which lifts the debt limit for two years and caps some categories of government spending, still needs to be approved by the House tomorrow.

 

The outcome of the vote is uncertain but the likely opposition by some Republicans means Democrat votes will be key. We expect the run-up to the vote to see Treasury Yields gradually climb higher if more lawmakers come out in favour of the deal.

 

Money markets can expect a $500bn liquidity drain over the coming months

Beyond tomorrow, US rates will quickly look past the deal and turn their attention to the Treasury's task of rebuilding its cash buffer at the Fed. Two aspects matter here. On the liquidity front, money markets can expect a $500bn drain over the coming months as more debt is issued. In a context of $95bn/month Quantitative Tightening (QT) and of likely tightening of at least some banks' funding conditions, this should amount to an additional drag on financial conditions for the broader economy.

 

This should ultimately draw a line under the US Treasury selloff but, should the new borrowing come with an increase in maturity, some of that support may be weakened.

 

The case for a June hike has strengthened after Friday's higher than expected core PCE print and Treasuries are set to trade softly into Friday's jobs report as recent prints have demonstrated the labour market's resilience. 4% yield for 10Y now seems a more achievable level.

 

Weak European data prevents EUR rates from rising as fast as their US peers

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