Congress has been unable to pass a full-year spending bill for the next financial year which means that all but essential government services will cease in the US until funding is agreed. Essential services such as military, medical, and law enforcement will continue, and the government will not pause issuance of new debt or interest payments on existing debt. However, the majority of administrative and regulatory functions will cease operations, with their employees sent home without pay or asked to continue working without immediate pay.
This shutdown is rather ill timed as concerns around the USA’s economic position are already growing following softer jobs growth. The US debt burden has increased by nearly $10 trillion in the last five years and there isn’t a clear plan for how the government will restore fiscal stability and close the deficit. Despite Trump’s most recent return to office being partly launched on a platform of fiscal responsibility and lowering debt, the decision to increase the debt ceiling to $41 trillion from $36 trillion was included as part of the recently passed “Big Beautiful Bill”, which has been projected to raise the US deficit by over $2tn. While the increase in the debt cap at least mitigates cliff edge debt fears by restoring a reasonably large buffer against the limit (current debt $36.5 trillion), it does not reassure markets that the USA is on a path to fiscal sustainability.
These concerns are part of the reason for the large shift in the US yield curve over the last year. In September 2024, short-term rates were elevated as inflation remained high and long-term yields were lower as markets expected rate cuts to feed through. This situation has flipped with short-term rates dropping by around 55bps whilst long-term rates, especially the 20- and 30-year levels, have increased by around 50bps. Short-term rates have been falling as labour market data reveals potential slowing in the job market which has prompted the market to price in more aggressive interest rate cuts. At the same time the term premium on long-term US debt is much higher than it was a year ago (despite recent falls) over concerns about rising borrowing and the fiscal deficit.
The shutdown will likely have an immediate economic impact from reduced consumption by furloughed employees who are sent home without pay, as well as any ancillary effects of slower public services as administrative government functions grind to a halt. Delays in passport and visa issuance are one example of this. There is also the possibility that Trump uses this opportunity to permanently fire some employees to reduce costs which would amplify any weakness in the job market. Most shutdowns tend to be short-lived, and have a reasonably small impact on the economy, but longer shutdowns may weigh on business and consumer confidence and can even have adverse market impacts as was seen in 2018’s government shutdown where the S&P 500 fell 13%.
Additionally, markets are currently pricing in more frequent cuts from the Fed as a result of weaker labour market activity. The government shutdown may cause a delay in the processing and release of the official labour market statistics, which could delay any further policy rate decisions taken by the Fed. If this does cause rates to be held at higher levels for longer than expected, this could put further pressure on economic growth and inflation, increasing the downside risk for rates over the medium term.
Downside risks of this shutdown are more likely to be felt if it continues for a prolonged period, which may lead to the market pricing in more rate cuts. Major debt functions of government will continue so there is no immediate risk to bond investors and T-bill holders. More prolonged disruption leading to delays in monetary policy decisions or higher term premiums for longer-dated debt could mean wider market disruption, but you’d hope that neither Republicans nor Democrats are likely to want the situation to get that far.
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