Bond investors are growing skeptical that the potential return of gridlock on Capitol Hill will ease their worries about the US fiscal trajectory the way it has for decades.

Polls suggest that political outcome is likely once again from US midterm elections on Nov. 3. Democrats are projected to wrest control of at least one chamber of Congress from the Republican Party, while falling short of gaining enough seats to override President Donald Trump's veto power.

Since the mid-1990s, a split Congress or government has often been a bullish recipe for Treasuries. Benchmark 10-year yields have been lower on average one and 12 months after midterms that produced such a result, Bloomberg-compiled data show. By making it harder to pass major spending legislation, that setup was seen as a sure way to rein in government spending and contain swelling budget deficits. 

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This time, investors doubt that legislative paralysis will be enough to bring yields down from around the highest in nearly a quarter century. The fiscal challenge has just become too daunting: Merely refraining from big new spending or tax-cut initiatives is no longer enough — politicians now would need to take steps to raise revenue or reduce outlays to offer investors a more constructive fiscal narrative.

The federal budget gap, at roughly 6% of the economy, has rarely been this large outside of a recession. And with debt held by the public surpassing $32 trillion, at a time of rising interest rates, annual net interest costs have climbed to a record above $1 trillion, more than the defense budget. 

"The bond market is looking for some sort of policy action to get the spending and debt under control," said Henry Song, a portfolio manager at Diamond Hill, which oversees $21 billion. "From that perspective, two years of impasse is not necessarily great because — if you just do the math — you're going to keep adding more debt to it in the next two years by doing nothing."

The bottom line is "the risk is for rates to go higher," Song said. "You're not really getting compensated enough" to buy long-term bonds yet.

Of course, the post-midterm bond performance also reflects the prevailing economic backdrop. In 2022, for example, when Republicans won control of the House as Democrats held the Senate and the White House under Joe Biden, the 10-year yield dropped more than a half-point in the subsequent month. It then rose over the following year as hot inflation extended the Federal Reserve's cycle of interest-rate hikes.

Next month's election comes during a bruising year for bonds, with the Iran war boosting energy prices, fanning inflation concern and pushing the Fed to lift rates for the first time in three years. Markets are also absorbing a wall of government debt issuance, which is competing with surging corporate bond sales to finance the AI boom. 

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Ten-year Treasury rates approached 5.4% this month, the highest since 2002, driving up mortgage costs and cooling the housing market. Investors say that unless Congress gets spending under control, government auctions will likely keep clearing at elevated yields. 

"It's odd that there's some argument that gridlock is a good thing for markets, because that happened in the past," said George Catrambone, head of fixed income at DWS Americas. 

"Having a dysfunctional congressional session next year or more government shutdowns is essentially putting this into the bond market's hands," he said. "Given how much rates have backed up, it would be a shame to have that repeated next year as I'm not sure the economy can handle it."

Some on Wall Street aren't ready to write off the midterms as a catalyst for fixed-income strength. 

In addition to stymieing spending bills, George Goncalves, head of US macro strategy at MUFG, sees scope for a Democratic wave to increase regulation around AI next year. In his view, that would support Treasuries because it would hurt stocks, slow the economy and reduce debt sales linked to AI. The bond market rallied last week on concerns over the outlook for AI companies, pulling the 10-year yield below 5% at week's end.

And while it would be a surprise given the polling, at least for the House, he also pondered a bond-bearish scenario where the vote keeps spending flowing. 

"A Republican win could be more challenging for bonds if it enables continued fiscal expansion," Goncalves said.

Refunding Twist

There's another wild card for the market next month, which may distort the signals from bonds following the midterms. The day after the election, the Treasury announces its quarterly refunding plans, which are seen as setting the stage for any substantial changes in debt-management policy. 

Analysts have speculated officials might seek to help lower yields through steps such as shrinking longer-maturity auctions and increasing sales of T-bills. Any hint that shift is ahead may help flatten the Treasury curve, with long-dated yields falling relative to rates on shorter maturities.

That would mimic the pattern seen after certain episodes of gridlock election results. The combination of a Democratic Congress and a Republican president in the weeks after an election has historically seen the yield curve flatten led by longer maturities, TD Securities strategists Molly Brooks and Gennadiy Goldberg wrote in a note. 

A gridlock outcome "should severely limit any new spending bills," they said. But even with that result in November, they still expect the deficit to climb to 6.4% of gross domestic product for fiscal 2027 from 5.9% as substantive changes to spending policy would be unlikely.

Ultimately, turnover in Congress may lead investors to demand higher yields, and the size of that effect could depend on the extent of any Democratic gains, said Joseph Abate, head of US rates strategy at SMBC. A bigger "blue sweep" could lead Republicans to focus on affordability issues and make them more open to Democratic proposals to increase spending, he said. 

"It doesn't matter which party you are talking about," said Sonal Desai, global chief investment officer for Franklin Templeton Fixed Income. "We just have profligates in power." 

She's neutral on US debt and in order to shift toward favoring US Treasuries, "we need to see some vigilantes come out," or a significant economic slowdown.