The electoral sweep by Democrats on Tuesday night injects a new, unstable dynamic into the single biggest political risk to financial markets in the coming year: the debt limit. Unless a defeated Republican Party makes a swift and unlikely show of unity to take the issue off the table in its last few weeks in power, the protracted fight that will unfold is set to be nastier than ever, adding volatility to an already shaky bond market.
Past episodes of brinkmanship around the need to raise the government's borrowing limit have involved Republicans in Congress demanding budget cuts from a Democratic president as the price of their vote. This time it will almost certainly be the left seeking concessions from the right.
The debt limit is the definition of a must-pass bill, even more than issues like funding the government and the defense budget. That makes it potentially the one real chance the new Democratic majority in Congress has to extract concessions from a president who is already pledging to veto their agenda. Markets will hate the entire process, even if — as many expect — it ends in compromise.
Because it is Democrats who hold the leverage, unlike past episodes, the ultimate agreement is more likely to increase government spending than lower it. With high bond yields weighing on the economy, and Americans expecting action from a newly empowered Democratic opposition, the fight could be particularly damaging.
Many in the markets are stuck on the outdated idea that Democrats are less assertive than Republicans, said Aniket Shah, head of the Washington policy team at the investment bank Jefferies.