Financial markets face a rocky road ahead as bitter partisanship in Congress appears likely to push U.S. debt ceiling negotiations down to the wire.

The U.S. Treasury hit its $31.381 trillion borrowing limit Jan. 19 and could run out of money before the summer if tax receipts come in light. The prospect of political inaction sleepwalking the U.S. into default is a major recession risk and likely to result in increased volatility in stocks and bonds.

Previous debt ceiling crises have caused the S&P 500 to slump, Treasury yields to skyrocket, consumer confidence to fall, economic growth to slow and led S&P Global Ratings to downgrade the U.S. government's credit rating.

Political polarization is even more acute this time around, with the recent historic difficulty in electing a speaker of the House of Representatives highlighting the significant divide in Congress that threatens to prolong the debt limit fight.

"If a resolution goes down to the last minute, or if the 'X date' [when the U.S. runs out of money to cover its debt obligations] is breached, then yes, I think there might be financial market volatility similar to past episodes," said Michael Pugliese, senior economist at Wells Fargo.

Fractious politicians

Congress has to agree to suspend or lift the debt borrowing limit in order for the Treasury to sell government bonds and raise the capital to meet its obligations, which include paying interest on outstanding debt, and the wages of post office workers and the military. Since hitting the debt limit in January, the Treasury is only able to borrow to replace maturing debt. Extraordinary funding measures, such as suspending investments in public sector pension funds and cash balances at the Fed — which totaled $568 billion as of Jan. 31 — allow the government to limp on for now.

The nonpartisan Congressional Budget Office predicts, however, that the government will exhaust those extraordinary measures as soon as July without a deal.

"At the end of the day, Congress really needs to raise the debt ceiling ... that's the only way out," Federal Reserve Chairman Jerome Powell told the Senate Banking Committee during a March 7 hearing. "If we fail to do so, I think the consequences are hard to estimate, but they could be extraordinarily adverse and could do longstanding harm."

The debt limit was last raised in December 2021 by $2.5 trillion to $31.4 trillion after Democrats swept U.S. elections in November 2020. This time around, negotiations will be more fraught as the Republican party won the House of Representatives in 2022 with 222 seats, four more than needed for a majority.

In the 2011 debt ceiling negotiation, Republicans were able to secure spending cuts from then-President Barack Obama, culminating in the Budget Control Act.

"This time, we don't expect Democrats would accept this premise, at least not meaningfully before the X-date," strategists at Morgan Stanley wrote in a Feb. 17 research note.

While a divided Congress traditionally would push negotiations on government spending to the wire, the Republican party itself is now split. Members of the House Freedom Caucus are not keen to do business with other Republicans, as made apparent in their repeated refusal to vote in favor of Kevin McCarthy as House speaker.

"Given the recent debacle with respect to appointing a speaker for the House, it seems that the Republicans may struggle to bring elements of their own party into line," said Mark Dowding, chief investment officer of BlueBay Asset Management.

The fraught negotiations in 2011 moved S&P Global Ratings to downgrade the U.S. government credit rating from AAA to AA+. In the current fight, Ratings expects a "protracted debate" before a resolution is found.

"We expect that Congress will engage in brinksmanship with the debt ceiling but will address it on time," Joydeep Mukherji, a credit analyst for Ratings, said in a Jan. 20 note.

Other rating agencies also predicted a protracted period of uncertainty before any agreement is made.

"A downgrade is possible, but it would probably take a very serious showdown for such an outcome to occur," Pugliese said.

A recurring problem

In 2011, Congress did not ratify an agreement until the day the U.S. would have run out of money to pay its debts. The ensuing market panic saw the S&P 500 slump in the weeks running up to the deal, while the U.S. credit downgrade came even after a deal was reached. Treasurys benefited as a safe-haven asset at the time, with yields on 10-year bonds only rising in the two weeks before the Aug. 2, 2011, resolution passed. Yields rise when bond prices fall.

In a similar standoff in 2013, however, Treasury yields rose sharply between the U.S. reaching the debt ceiling in May and the run-up to an October resolution that averted a further crisis.

"At the moment, I expect a last-minute deal, meaning one or two weeks of heightened volatility like in 2013, but not the extreme fear gripping the market like in 2011," said Joachim Klement, a strategist at investment bank Liberum. "Of course, it will all depend on how much both the Democrats and Republicans are willing to compromise."

In 2023, interest rates and earnings reports are driving financial markets. That may change if political brinkmanship raises the prospect of the U.S. sleepwalking into a default, increasing the risk of holding government debt.

"It just raises the overall perception that our government is dysfunctional," said Joel Prakken, chief U.S. economist at S&P Global Market Intelligence.