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Market Extra: Debt-ceiling showdown could shake up markets after midterm-election results become clear, analysts say

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The final results may not be clear until possibly December, but the U.S. midterm election’s outcome is still seen likely to have a significant impact on financial markets.

With control of the House and Senate too close to call as of Wednesday morning, one of the biggest consequences of Tuesday’s election is the likelihood of a renewed fight over the debt ceiling if Republicans take either chamber of Congress. That’s the legal limit on how much national debt the U.S. Treasury can incur and if the ceiling isn’t raised on time, the U.S. could theoretically default.

Treasury could approach the roughly $31.4 trillion debt limit during the current quarter, though economists note that “extraordinary” fiscal maneuvers would allow the government to avoid hitting the ceiling until some time in 2023.

Read: Breaching the U.S. debt ceiling would be a ‘disaster’ for Americans, expert says, as possible showdown looms if Republicans win midterms

“The threat of a renewed debt ceiling cliff-edge is not simply speculation,” said Henry Allen, a research analyst at Deutsche Bank. “A number of senior Republican officials have openly advocated using the debt ceiling as leverage with the Democrats in order 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,” Allen wrote in a note this week.

One needs to go back more than a decade to see what happened during the last major showdown over the debt ceiling: Based on the performance of the S&P 500 in 2011, the biggest slump of that entire year occurred from late July into August amid jitters that the U.S. might default on its obligations, according to Deutsche Bank. The slump in the S&P 500
SPX,
-0.44%

was accompanied by a sharp decline in the Conference Board’s consumer-confidence indicator, so the potential for future volatility this time around “is clear,” Allen said.

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 U.S. at risk by preventing Treasury from paying the government’s bills.

Read: U.S. Treasury expects to borrow $550 billion in fourth quarter

According to a Nov. 1 note by analyst Joseph Abate, Barclays
BARC,
-0.42%

expects Treasury to start using extraordinary measures and cash reserves in December. But Abate says that both will likely run dry next September.

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

Expectations for a big win by Republicans have been dashed, for now, along with the hopes that such an outcome would provide a short-term pop for stocks. On Wednesday, all three major stock indexes
DJIA,
-0.45%

SPX,
-0.44%

COMP,
-0.70%

opened lower after posting three straight days of gains. Meanwhile, most Treasury yields, with the exception of rates on T-bills, headed higher — led by the 30-year yield
TMUBMUSD30Y,
4.282%
.

Democrats currently hold a slim House majority and control the Senate through the tiebreaking vote of Vice President Kamala Harris. Republicans have been seen as likely to “throw a wrench into the aggressive fiscal spending plans the Democrats would still like to get done,” according to Mike Wilson, Morgan Stanley’s chief equity strategist.

Need to Know: How to play defense with your portfolio in this tough market and still maintain upside potential? This strategist will tell you

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