USD Rates: Debt ceiling and fiscal tightening

Medium-term bias to receive USD rates
Group Research, Eugene Leow23 May 2023
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    Markets stayed optimistic with 2Y and 10Y yields closing above 4.30% (hit our forecast for 2Q) and 3.70% (we peg our forecast at 3.9% for 2Q) respectively. At current levels, banking crisis fears have been largely unwound. Debt ceiling worries are also being pared with the 1Y US EUR CDS dropping meaningfully over the past week. While US yields might take a pop higher when the debt ceiling gets lifted, we think that upside might be limited as a chunk of the positives may already be in the price and stick with our rec bias from here on. 

    Parsing the debt ceiling issue requires the stripping out of political noise as the X-date nears. Beyond the likely meandering path towards a resolution, we should also have a view on the medium-term implications on what the lifting of a debt ceiling would likely entail. In the immediate term, as we track closer to the X-date, there will likely be more volatility, driving risk aversion. The seriousness of this event would then depend on whether a deal is struck before a government shutdown occurs (similar to what happened during the Clinton administration in 1995/96). If a deal is struck well before the X-date, we should reasonably assume that the Democrats would have to provide meaningful concessions in the form of spending cuts.

    This should be viewed as contractionary over the medium term. Twin tightening (monetary and fiscal) should slow the economy and put downward pressures on inflation. Hence, even if this risk event gets cleared (which should help sentiment and perhaps lift yields a tad), there is a need to focus longer term. A sizable amount of tightening has already taken place. With the fiscal boost from the pandemic fading and another leg of fiscal tightening likely, we prefer to focus on the medium term, sticking to our receive bias for USD rates.

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
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