Bond Watch: what the US government shutdown means for markets

At 4am on 1 October (midnight Washington DC), the US federal government shut down for the first time since 2019.

A stop-gap funding bill, approved in the Republican-controlled House of Representatives, fell five votes short of passing in the Republican-controlled Senate, despite a handful of Democrat supporters. Objections included calls for tax credit extension and rejected cuts to Medicaid and government health agency spending.

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Shutdowns are disruptive domestically. They mean millions of dollars wasted, furloughed federal workers, frustrated policymakers and uncertainty for companies (particularly those working with the government). The impact on investors is less clear-cut. However, for investors, the US government bond market response has so far been fairly muted and the S&P 500 actually touched new highs on Wednesday (1 October).

Modest spikes in yields across the curve (see the bottom of this article for an explanation) while shutdown loomed on Tuesday have quickly subsided.

From an operational point of view, US government bonds (US Treasuries) generally remain unaffected during a shutdown, as essential operations such as coupon payments and debt auctions continue. 

What this means for investors in the near term

With federal departments shut, there’s a possibility that the non-farm payroll report, which the fixed-income market and the Federal Reserve monitor as a yardstick of US economic health and a key piece of data for the next rate decision (28-29 October), may not be published today (3 October), with other data being relied on.

However, while there’s scope for volatility, historically a shutdown has led to a drop in short-term yields as money flows to the perceived safety of short-dated Treasury bonds – indeed yields of shorter maturity issuances are now lower than at the start of the week.

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Shutdowns tend to be short. The longest on record was 35 days during Donald Trump’s first presidency (surpassing 21 days under Bill Clinton). However, President Trump has indicated that he will look to use this as a chance to purge federal government and may hope supporters will share his view in blaming opposition for the standstill.

Rhetoric regarding the reasons for shutdown has been charged - perhaps there’s reason to suspect this might not be a “typical” shutdown.

What this means in the long term

Shutdowns aren’t too frequent in the US. There’s been a handful so far in the 21st century (one lasting a matter of hours) born from various points of contention, with most taking place from 2018 onwards. This latest instance shows that, despite the Republican Party’s majorities in both House and Senate, a failure to pass stop-gap funding still underscores political division and a lack of cohesion in addressing rising debt-to-GDP and persistent deficits via fiscal policy.

Repeated political stand-offs could ultimately see investors and credit agencies alike question US fiscal governance. While the Federal Reserve rate will define the short end of the curve, there’s potential for steepening of the yield curve if confidence in the US’ ability to overcome fiscal adversity erodes.

What is the bond yield curve?

The yield curve is a chart that plots the relationship between yields and maturity dates. 

Normally, bonds with longer lifespans such as 30 years have higher yields than shorter-duration bonds that might be just a few years away from maturity.  

However, this isn’t always the case, and the yield curve can invert, resulting in longer-term bonds trading on lower yields than short-term bonds. 

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When this happens, it can reflect investor concerns about the short-term economic outlook, as they are willing to accept less income to lend for longer. 

Bond yields typically “curve” up with increasing contract length. Future inflation expectations are a big driver behind the shape of the yield curve. If inflation is expected to be higher in the years to come, yields will, in theory, rise across the curve.