US Government Shutdown: Treasury Yield Implications

• Last Wednesday, the US government entered a partial shutdown due to a budget standoff in Congress between Republican and Democratic Politicians.While shutdowns are nothing new in Washington, this one arrives in a fragile moment with rising fiscal deficits and slowing growth making investor sentiment unusually sensitive to macroeconomic changes. 

• In this Cordoba note we explore what the shutdown means for US fixed income markets, from Treasury yields and credit risk to Fed policy expectations.
  

Background

• Under the US system, government services can only remain funded if Congress passes a new spending bill. When no agreement is reached, non-essential operations shut down.
  
• Although Republicans control both the House and Senate (the two government chambers), Senate rules require 60 votes to pass most major bills. With fewer than 60 Republican Senators, the party is unable to pass a spending bill on its own, providing Democrats negotiating power.
  
• Democrats want to protect healthcare provisions, such as tax credits which lower insurance costs and Medicaid funding, while Republicans are pushing for spending cuts. This has led to a stalemate, failing the stopgap funding measure, and triggering the first shutdown in 7 years.

• Historically, government shutdowns have occurred on multiple occasions with an average length of 8 days over the past 50 years, typically having limited market impact when brief. However, longer shutdowns can have more pronounced economic effects. Oxford Economics estimates a partial shutdown trims GDP growth by about 0.1-0.2% points per week of duration.
  

Data Releases and Fed Policy

• A key consequence of the shutdown is the suspension of federal data publications, including nonfarm payrolls, CPI, retail sales, and GDP updates. The recent September labour statistics due 3rd October was suspended and weekly jobless claims were not released.

• With the Federal Reserve facing a data vacuum just weeks before its next policy meetings, market expectations have changed. Analysts now see a higher probability of a dovish stance, with signalled rate cuts supported by the absence of data and the risk of further GDP slowdown.

• This has been priced in with Fed fund futures pricing in roughly 45 points of easing by the end of 2025. Traders have increased the probability of a rate cut significantly as a result.
  

Treasury Yield Curve Movements

• Treasury yields have responded quickly to shutdown uncertainty and rate cut prospects, falling sharply in recent days. The 2-year yield (which is highly sensitive to policy expectations) dropped to roughly 3.54%, a two week low, while the 10-year yield eased toward 4.1%, down from recent highs.

• The result has been a sharp bullish steepening of the curve. The 2s10s spread, which had been inverted for much of the past year, has now become positive at around +55 basis points. This move indicates markets are increasingly pricing in imminent Fed easing at the short end, while long-term yields remain relatively stable.

• In the near term, the steepening is being driven almost entirely by front-end moves. The long end has been relatively stable but could rally further if the shutdown drags on and growth risks further. Historical shutdown data supports this as during the 2018-2019 shutdown, the 10-year yield fell nearly 50 basis points as fears of a broader economic slowdown increased.
  
• Credit risk perceptions have increased but remain modest. Five-year CDS spreads on U.S. Treasuries widened to around 42 bps, their highest since July, while one-year CDS sits near 21 bps. However, this rise reflects heightened governance uncertainty rather than a default risk, since the shutdown does not affect Treasury’s ability to service debt, as echoed by credit rating agencies.

Market Implications

• For now, equity markets have largely ignored the shutdown, with U.S. and European indices reaching near record highs perhaps as investors focus more on Fed easing than the political situation. The dollar has weakened modestly, consistent with expectations of lower policy rates, while gold has risen toward record levels on safe-haven demand.

• The fixed income market is more immediately exposed. If the shutdown is resolved quickly, its impact will likely be temporary, with yields stabilising and attention returning to fundamentals such as data releases and Fed guidance.

• But if the impasse stretches beyond a few weeks, the economic drag could be significant. That would raise expectations of further Fed easing, pushing the 2-year yield lower, and potentially driving a more decisive rally at the long end. In such a scenario, the curve could steepen further in the short term, before flattening again if growth scares drastically increase.

Our View

• From a short-term positioning standpoint, we favour maintaining duration exposure at the front end of the curve as Fed cuts are pricing in aggressively. The steepening trend provides scope for relative value trades such as a curve steepener to benefit off the roll-down of the curve. 

• If the shutdown extends, we could see more safe-haven flows into the long end of the curve, supporting a long strategy in the 10Y and 30Y Treasuries, which many asset managers are already considering.

• Overall, the shutdown has driven safe-haven flows into Treasuries, temporarily overriding the previous fiscal risk concerns dominating the long-end. The key question is whether long-term yields will resume their upward trend post-shutdown or if this marks a more lasting change in investor confidence.