Relief Rally Expected in Global Markets as US Nears Debt Deal.

Introduction

Global markets are poised for a relief rally following the tentative agreement reached by US negotiators over the weekend to resolve the lingering debt crisis. The debt issue had weighed on risk sentiment in recent weeks, prompting investors to flock to safe-haven assets. However, with the prospect of a resolution, market participants anticipate a positive response, although the full extent of the relief rally may only become clear after the deal passes Congress. Let's delve deeper into the implications of this agreement and its potential impact on various markets.

The Debt Deal and Market Sentiment

The agreement between US negotiators has instilled confidence in investors, who now expect the deal to pass Congress and avert a historic US default. This development has led to a positive market sentiment, with equity futures in the US making modest gains, and Treasury futures exhibiting mixed reactions due to the absence of cash trading. The US dollar, which has been bolstered by concerns surrounding the statutory borrowing limit, initially experienced losses but later erased them amid thin liquidity caused by national holidays in the US and UK.

The balanced nature of the deal, which aims to reduce spending without compromising growth, has been well-received by strategists. Chang Wei Liang, a strategist at DBS Group Holdings in Singapore, believes the deal will be a small positive for US Treasuries. However, the full impact of the relief rally may only be realized later in the week after Congress votes, considering the absence of many traders in the US, UK, and parts of Europe on Monday.

Implications for Bond Markets

In response to the debt deal, European government bonds experienced gains, causing the yield on the 10-year German benchmark to decrease by 10 basis points. This reversal ended five consecutive days of losses. Meanwhile, Treasury futures for short-maturity debt remained relatively unchanged, reflecting mounting expectations of an interest rate hike by the Federal Reserve. Futures tied to long-maturity Treasuries rallied, suggesting that yields for 10- to 30-year bonds are expected to decline once cash trading resumes.

Foreign Exchange Dynamics

Currency markets have responded differently to the debt crisis. The Australian dollar climbed 0.3%, recovering from a 2% drop the previous week. In contrast, the euro slipped, while the pound held steady. Interestingly, the US dollar, despite the risk of a default, has performed strongly against all G-10 currencies this month. This reflects the US's unique position at the center of the global financial system, where investors seek the safety of dollar-denominated assets like Treasuries during times of uncertainty.

The Aftermath and Future Challenges

While market sentiment remains generally positive, investors are cautiously awaiting the passage of the debt deal through Congress before making further commitments to risky assets. However, concerns persist about potential objections from hard-liners in both parties, necessitating further negotiations to secure the required votes. Quincy Krosby, chief global strategist for LPL Financial, acknowledges the expectation that McCarthy and Biden will prevail but warns of the need for further negotiations to win over staunch critics.

The costs of the prolonged political wrangling have already taken a toll, with the US Treasury incurring additional expenses. The government's subsequent efforts to replenish its coffers after reaching a deal are anticipated to drain liquidity from the banking system, adding pressure on US banks already grappling with months of turmoil. The influx of bill supply could further bolster the US dollar, leading to potential persistent strength due to the impact on financial system liquidity.

Conclusion

The tentative debt deal reached by US negotiators has buoyed global markets, which are primed for a relief rally after weeks of uncertainty. Investors are hopeful that the agreement will pass Congress, averting a US default and restoring stability. Bond markets have shown mixed reactions, with long-maturity Treasuries rallying and short-maturity debt remaining relatively unchanged. The US dollar has performed strongly despite the risk of default, highlighting the currency's safe-haven status. While the relief rally is anticipated, the full extent of the market's response may only become evident once the deal is finalized and passed by Congress.