The debt-ceiling showdown could shake up the market after the midterm-election results, analysts say

The results won’t be clear until Tuesday night or possibly for several days, but the results of the US midterm elections are poised to be an important event for financial markets.

With the Republicans favored to win control of both chambers of Congress, according to ABC News’ Fifty Thirty Eight online election prediction site, one of the biggest consequences of such results will be the chances of a renewed fight over the debt ceiling. That’s the legal limit on how much national debt the US Treasury can carry and if the ceiling isn’t raised in time, the US could theoretically default.

The Treasury could approach the debt limit of about $31.4 trillion during the current quarter, although economists say that “extraordinary” fiscal maneuvers will allow the government to avoid the ceiling until sometime in 2023.

Read: Breaching the US debt ceiling would be a ‘disaster’ for America, experts say, as possible showdown emerges if Republicans win midterms

“The threat of a renewed debt ceiling cliff-edge is not just speculation,” said Henry Allen, research analyst at Deutsche Bank. “A number of senior Republican officials are openly advocating using the debt ceiling as leverage with Democrats to extract policy concessions, as they did in 2011.”

The potential financial-market consequences of a renewed fight over the debt limit “are still underappreciated,” wrote Allen in a note on Monday.

We have to go back more than a decade to see what happened during the last major fight on the debt ceiling: Based on the performance of the S&P 500 in 2011, the biggest slump of the year took place from late July to August in the middle of the unrest. The US may default on its obligations, according to Deutsche Bank. The decline in the S&P 500 SPX,
+1.21%
This is accompanied by a sharp decline in the Conference Board’s consumer confidence indicator, so the potential for future volatility around this time is “obvious,” said Allen.

Source: Bloomberg, Deutsche Bank

Rather than constraining federal spending, the debt ceiling – if set below the level needed to meet the government’s borrowing needs – theoretically puts the full faith and credit of the US at risk by preventing the Treasury from paying government bills.

Read: The US Treasury expects to borrow $550 billion in the fourth quarter

According to a Nov. 1 note by analyst Joseph Abate, Barclays expects the Treasury to begin using extraordinary measures and cash reserves in December. But Abate said both are likely to dry up next September.

“We estimate that today’s extraordinary measures give the Treasury an additional $350 billion in above-the-limit borrowing capacity,” Abate wrote. “Depending on how long debt ceiling negotiations drag on in Congress, the Treasury could add to this total” through other actions.

For now, the most immediate impact on the market from a big victory by the Republicans is that it can provide a short-term pop for stocks, according to Mike Wilson, Morgan Stanley’s chief equity strategist. Although he remains bearish on the long-term for stocks, Wilson has an upside target in the 4,000-to-4,150 range for the S&P 500, which was trading around 3,836 on Tuesday morning.

Democrats now hold a slim House majority and control the Senate through the tiebreaking vote of Vice President Kamala Harris. Republicans are likely to “throw a wrench into the aggressive fiscal spending plan Democrats still want to finish,” Wilson said. So a Republican takeover of at least one chamber of Congress has the potential to raise the attractiveness of long-dated Treasurys and pull down the yield, which moves in the opposite direction of the price.

As of Tuesday morning, all three major stock indexes DJIA,
+1.48%

comp,
+1.43%
which is headed higher, extending the gains seen on Monday and Friday. Meanwhile, most Treasury yields, except for rates on 3- and 6-month bills, were lower – led by the decline in the 7-year yield TMUBMUSD07Y,
4.238%.

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