The debt deal could boost unloved parts of the US stock market

By Laura Matthews and Chibuike Oguh

(Reuters) – Global investors are pondering how an interim agreement to raise the US debt ceiling could affect markets as lawmakers seek to pass the agreement before the June 5 deadline through Congress.

A deal to remove the $31.4 trillion debt ceiling, announced by the White House and House Republicans late Saturday, would avert a catastrophic U.S. bankruptcy and increase broader risk appetite, while providing a boost to some of the sectors that are at risk lagged behind this year's tech-driven rally, such as cyclical stocks and small-caps, investors said.

E-mini futures for the S&P 500 were up 0.5% in futures trading Sunday night.

However, some investors worry that the proposed spending cuts could weigh on US growth. At the same time, a negotiation process that only narrowly prevented a default is threatening to undermine the USA's reputation with the rating agencies.

“While the White House debt ceiling agreement is good news, the US government still has a cash flow problem and time is ticking to finalize the deals,” said Bob Stark, global head of market strategy at Treasury and… Financial management company Kyriba. “The debt ceiling agreement is only the first step to save the government from illiquidity.”

The deal suspends the debt ceiling until January 2025 in exchange for spending caps and cuts in government programs. Narrow majorities in the House and Senate mean moderates on both sides must back the bill.

US Treasury Secretary Janet Yellen on Friday set a deadline for raising the federal debt ceiling and said the government will default if Congress doesn't raise the debt ceiling by June 5.

Almost missed?

With the $24.3 trillion US Treasury bond market forming the foundation of the global financial system, a default – or even a tight decision – could trigger massive volatility in global markets.

Uncertainty weighed on stock markets regularly last week, although most investors and analysts said they expected an eleventh-hour deal. Optimism that a debt ceiling deal is imminent and strong gains in AI-related stocks helped the S&P 500 close Friday at its highest level since August 2022. In the year to date, the figure has risen by 9.5%.

Market sectors likely to benefit from a deal include defense stocks, which have lagged during negotiations, as well as cyclical market sectors and energy stocks, said Quincy Krosby, chief global strategist at LPL Financial.

“The hope is that the approval of this tentative deal will help bolster the broader market and not just the handful of big tech companies that have been keeping the market well in positive territory,” she said.

Stuart Kaiser, head of equity trading strategy at Citi, said a deal could be “modestly positive” for stock markets at the index level but could provide a bigger boost to sectors that have lagged this year, including stocks of companies with weaker balance sheets and small -Cap stocks.

However, market participants are also concerned about the impact the proposed spending caps will have on specific sectors as well as on the US economy in general.

“What investors will focus on now is the cost to the health of the American economy of spending cuts,” Stark said. “What impact will these spending cuts have on GDP and economic growth?”

Meanwhile, the risky machinations in Washington could also prompt the rating agencies to downgrade the US debt. Rating agency Fitch late Wednesday alerted the United States' credit rating to a possible downgrade, while DBRS Morningstar on Thursday issued a “negative impact” review of US credit ratings.

S&P Global Ratings stripped the United States of its coveted top rating over a debt ceiling dispute in 2011, just days after a last-minute deal that the agency at the time said failed to stabilize “medium-term debt dynamics.”

The downgrade contributed to a decline in US stocks that caused the S&P 500 to lose about 17% between late July and mid-August 2011.

S&P Global Ratings, Fitch and Moody's did not immediately respond to Reuters requests for comment.

Investors are also bracing for potential volatility in U.S. Treasuries, as the Treasury Department is expected to quickly fill its tight coffers with bond issuance once the debt ceiling is raised, potentially draining hundreds of billions of dollars in cash from the market.

“We will be optimistic that a deal will materialize and a real crisis will be averted while also experiencing the dreaded liquidity drain,” said Damien Boey, macro strategist at BarrenJoey in Sydney, Australia. “I think you're going to find that. Interest rate volatility will increase and this will cause banks and non-AI growth stocks to become laggards.”

(Reporting by Laura Matthews, Chibuike Oguh, Tom Westbrook, Saqib Iqbal Ahmed and David Randall; Editing by Ira Iosebashvili, Michelle Price and Mark Porter)

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