As we look ahead to the US midterms on Nov. 9, the question traders ask is whether it has the potential to be a risk event and promote increased cross-market volatility – as part of the risks assessment, the election has implications on whether to reduce trading exposures over the event.
Anecdotally it feels like traders aren’t giving the elections too much importance and are looking far more intently at this week’s FOMC meeting. It’s hard to disagree with that stance as trading ‘peak rates’ is the dominant trading theme - where bad news is good for risky assets, and good news (especially labor market data) is bad for risky assets. However, the makeup of Congress does matter for US economics, even more so given the US is increasingly headed towards a recession and could require fiscal support.
As we move closer to the 2024 Presidential elections, there is little doubt a split Congress will increase the brinkmanship between the two parties. However, whether this leads to significant market volatility is debatable.
When will we get a result?
An important aspect of the midterms is timing. When exactly will we have a clear understanding of who will control the Senate and the House? the market naturally wants certainty and an immediate outcome. This is unlikely, and trading the midterms means reacting to news as it comes in state by state.
With so many choosing to vote by mail, we know that in some states, it's only when the polls close on election night that the mail votes are counted. It may be too close to call in some states, and we must wait for the full mail vote to be counted – this suggests we may not get a firm result for the Senate and House on election night.
The playbook
We explain the dynamics of the US midterms for traders in our recent piece. We can assess contestable seats and how many seats each party needs to obtain to win each chamber.
The betting markets have Republicans winning both the House and Senate.
As it stands, PredicIt has the House and Senate going to the Republicans (REP) comfortably – betting markets have a 90% probability the REP claims the House and a 73% chance of controlling the Senate. In the eyes of the market, it’s not even a debate that the REPs claim the House, it’s a lock. The battle for the Senate is where we could see some uncertainty, and while the REPs are expected to be victorious, it's not a done deal.
So, the strong base case in the market’s eyes is that we have Biden in the White House and REPs controlling both chambers of Congress. This outcome has implications that can affect markets, so let’s consider the following:
Fiscal policy
In a world where inflation is very high, governments are already constrained on future stimulus, especially if it leads to increased bond issuance. However, as the probability of a recession increases, the need for government assistance also rises so that President Biden may propose a stimulus package. Still, the REPs would likely reject it in either the House or Senate. In theory, from a fiscal perspective, this scenario is a modest USD negative.
In the far less probable scenario where the DEMs maintain control of Congress and the White House - should the economy need it, then they would be able to pass a sizeable fiscal package – in a recessionary backdrop with rising unemployment, supporting deteriorating economics would soon take priority over inflation – this outcome would therefore be USD positive as it could lift US Treasury yields.
Borrowing constraints
With REP potentially controlling Congress, we consider the possibility of another debt ceiling and govt shutdown debacle – in recent times, the market has become quietly comfortable with both issues. A re-run of the volatility seen in 2011 seems highly unlikely. However, if the REPs tow a fiscal prudence line and push for reduced government spending, we could easily be facing a brinkmanship event and a game of who blinks first.
While most of the volatility will be centered on ultra-short-term US debt instruments (T-bills), a standoff on the debt ceiling would be USD positive, although the clearer trade would be shorting equities – and as we push close to the debt ceiling deadline, the equity market would become ever more nervous and de-risk.
Geopolitics
It's hard to draw a clear conclusion on this from a market perspective, and while we can look at the US’s relationship with China and Russia, there doesn’t seem to be a clear market catalyst here.
In theory, a REP-controlled Congress and Biden in the WH is a modest USD negative, while conversely, the debt ceiling debate is bullish for the USD. So with no dominant directional catalyst, traders will continue to trade the ‘peak rates’ theme but will keep a close eye on the midterms for voting trends in case it does surprise and proves to be a volatility event.
However, with a recession a rising probability and the government unlikely to be able to support through fiscal channels, it puts all the emphasis back on the Fed – that means their reaction function will need to be sharper, and they will need to be ready to shift policy more aggressively if the economy is to go downhill rapidly.
In some ways, this politicizes the Fed, with the economy shaping up to be the key agenda for the 2024 Presidential election.