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Market Extra: Bond market sees gridlock in Washington even before midterm election results roll in, traders say

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It will take many more hours and maybe even days before the final results of Tuesday’s U.S. midterm elections are in, but the bond market has already come up with what it considers to be as the most likely outcome.

That outcome is gridlock, according to traders. The likelihood that Republicans will take control of at least one chamber of Congress was seen as one of the biggest reasons why investors were flocking back into Treasurys on Tuesday — sending most yields lower, with the exception of rates on 3-
TMUBMUSD03M,
4.159%

and 6-month bills
TMUBMUSD06M,
4.618%
.

Financial markets were assessing a multitude of likely consequences if Republicans take the House, the Senate, or both — such as the risk of a renewed fight over the debt ceiling. Democrats currently hold a slim House majority and control the Senate through the tiebreaking vote of Vice President Kamala Harris. But Republicans are favored to win control of both chambers, based on ABC News’ FiveThirtyEight online election-forecast site.

If they do take control, Republicans are seen as likely to throw a wrench into any of the Democrats’ aggressive fiscal spending plans and may be loathe to support a government-led rescue if the U.S. tips into a recession, analysts said. Anticipated gridlock in Washington is also expected to tie the Federal Reserve’s hands — keeping policy makers from hiking interest rates as much as they otherwise would.

“We see markets interpreting the midterm elections as Republicans taking one of the chambers of Congress, which means we are looking at gridlock and are not going to see a lot of spending,” said Larry Milstein, senior managing director of government debt trading at R.W. Pressprich & Co. in New York. “It’s fair to say that there will be no government riding to the rescue” if the Fed’s interest rate hikes tip the U.S. into a recession, he said via phone.

Bond investors have been vacillating between two narratives this year: One is that persistent inflation will lead to continued aggressive rate hikes by the Fed, and the other is that the threat of a U.S. recession will force policy makers to back off. The next major inflation update is set to be released on Thursday.

As of Tuesday, the bond market was moving on what appeared to be the likelihood of at least a Republican takeover of the House, which implies “there is not much in the way of new legislation that is likely going to get done in the next two years,” said Tom di Galoma, managing director of rates trading at Seaport Global Holdings in Greenwich, Conn. “That’s good for stocks and most likely good for bonds because it means the Fed won’t be able to tighten to infinity. The economy is going to rely solely on the Fed.”

Tuesday’s drop in Treasury yields was led by a decline in the 7-year rate
TMUBMUSD07Y,
4.230%
,
which fell 10 basis points to 4.21%. The 3-month yield jumped 9 basis points to 4.18%, while the policy-sensitive 2-year rate dropped to 4.65%.

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