Analysis-Debt deal welcomed by investors, though risks loom

© Reuters. FILE PHOTO: A security fence surrounds the U.S. Capitol building ahead of the president’s State of the Union address and concern over possible protests in Washington, U.S., February 28, 2022. REUTERS/Leah Millis

By Laura Matthews, Chibuike Oguh and Herbert Lash

(Reuters) -Global investors are gaming out how a tentative deal to raise the United States debt ceiling could ripple through markets, as lawmakers strive to pass the agreement through Congress before a June 5 deadline.

A deal to lift the $31.4 trillion debt limit announced by the White House and House Republicans late Saturday would avert a catastrophic U.S. default and boost overall appetite for risk, while also buoying some of the sectors that have been left behind in this year's tech-led equity rally, such as cyclical stocks and small caps, investors said.

The initial reaction was positive. Wall Street futures rose, with S&P 500 e-minis up 0.3% and Nasdaq e-minis up 0.5%. U.S. Treasury note futures were up around 0.2% in a sign that U.S. Treasury yields, which move inversely to prices, will fall when bond trading resumes. U.S. markets were closed on Monday for a public holiday.

U.S. five-year credit default swaps narrowed, meaning that the cost of insuring against exposure to a U.S. debt default fell. The U.S. dollar index was steady at 104.26.

But some investors are wary that proposed spending cuts could weigh on U.S. growth. At the same time, a negotiation process that barely avoided a default threatens to undermine the U.S. standing with credit ratings agencies.

“While the White House's debt ceiling agreement is great news, the U.S. government still has a cash flow problem and time is of the essence to finalize the agreements,” said Bob Stark, global head of market strategy at treasury and financial management firm Kyriba. “The debt ceiling agreement is only the first step in saving the government from the brink of illiquidity.”

The deal suspends the debt ceiling until January 2025 in exchange for caps on spending and cuts in government programs. Narrow margins in the House of Representatives and Senate mean that moderates from both sides will have to support the bill.

U.S. Treasury Secretary Janet Yellen on Friday set a deadline for raising the federal debt limit, saying the government would default if Congress does not increase the debt ceiling by June 5.

Spending freezes will force the economy to function more on its own than it has had to do for several years, said Steven Ricchiuto, U.S. chief economist at Mizuho Securities USA LLC in New York.

"That’s going to be an adjustment process, especially this shrinking in real spending," he said. "It's more of an economic situation than a market situation."

NEAR MISS?

Since the $24.3 trillion U.S. Treasury market underpins the global financial system, a default - or even a close call - could trigger massive volatility across global markets.

The uncertainty periodically weighed on stock markets over the last week, although most investors and analysts said they had expected an 11th-hour agreement. Optimism that a debt ceiling deal was near and hefty gains in AI-related stocks helped the S&P 500 close at its highest level since August 2022 on Friday. The benchmark index is up 9.5% year to date.

Among the market sectors that stand to benefit from a deal are defense stocks, which have lagged during the negotiations, as well as cyclical sectors of the market and energy stocks, said Quincy Krosby, chief global strategist at LPL Financial (NASDAQ:LPLA).

“The hope is that the approval of this tentative deal will help underpin the broader market and not just the handful of big tech names that have kept the market well in positive territory,” she said.

Stuart Kaiser, head of equity trading strategy at Citi, said a deal could be a “modest positive” for equity markets at the index level but could provide a greater boost for sectors that have lagged this year, including shares of companies with weaker balance sheets and small-cap stocks.

But market participants are also wary of how proposed spending caps will impact specific sectors as well as the broader U.S. economy.

“What investors will now focus on is the cost of the spending cuts to the health of the American economy,” Kyriba's Stark said. “How much impact will these spending cuts have on GDP and economic growth?”

The brinkmanship in Washington could also prompt rating agencies to downgrade U.S. debt. Ratings agency Fitch late Wednesday put the United States on credit watch for a possible downgrade while DBRS Morningstar on Thursday placed U.S. credit ratings under review with "negative implications."

S&P Global (NYSE:SPGI) Ratings stripped the United States of its coveted top rating over a debt ceiling showdown in 2011, a few days after a last-minute agreement that the agency at the time said did not stabilize "medium-term debt dynamics."

The downgrade contributed to a decline in U.S. stocks that saw the S&P 500 lose some 17% between late July and mid-August of 2011.

"The risks of a downgrade are still there. It's important that lawmakers take this serious and are not posturing, or trying to appease their bases," said Edward Moya, senior market analyst at OANDA in New York.

S&P Global Ratings, Fitch and Moody's (NYSE:MCO) did not respond to Reuters requests for comment.

Investors are also bracing for potential volatility in U.S. government bonds as the Treasury is expected to quickly refill its empty coffers with bond issuance once the debt ceiling is raised, potentially sucking hundreds of billions of dollars of cash from the market.

"We will get the optimism that a deal is done and that a real crisis is averted, and the dreaded liquidity drain at the same time,” said Damien Boey, macro strategist at BarrenJoey in Sydney, Australia. “I think you will find that interest rate volatility will rise, and this will cause banks and non-AI growth stocks to be laggards."