With markets having mostly digested the Federal Reserve’s change in reaction function, and the rout in risk assets of Q1 and Q2 now comfortably in the past, the US election stands out as the second biggest source of uncertainty for global macro markets, after the ongoing Covid-19 pandemic. This is not an ordinary situation. US elections rarely offer such drastic prospects for policy change that they significantly alter the global macro outlook.
However, November’s election offers the prospect of almost unprecedented divergence between the likely outcomes for trade and fiscal policy between a Biden and Trump administration and the even more unprecedented prospect of a disputed election.
As a result, the election outcome and aftermath will be uniquely significant for macro markets, including FX.
Calling the impact of an election on a currency, and wider macro markets, is difficult. Many pundits expected a market rout in the event of Donald Trump’s election in 2016. Such a rout did indeed ensue in the immediate aftermath of the election result becoming clear, leading Nobel Laureate Paul Krugman to declare that a “first pass” answer for when markets will recover was “never”. Within mere hours of Krugman’s comment going to print, Donald Trump’s victory speech promised massive fiscal stimulus and infrastructure spending. Equity markets rallied, the dollar just about went back to where it began, and the next couple of months were dominated by a reflationary “Trump trade”. Macro markets during the ensuing years of Donald Trump’s presidency were no less dominated by his administration’s policies, notably during the costly US-China trade war. As the last four years have demonstrated, fiscal and trade policy are of paramount importance to US and global macro markets. This theme will continue in the aftermath of the upcoming election, with a stark contrast between the outlook under alternative Biden and Trump administrations.
Dollar Volatility and sell-off on election night 2016 was followed by Dollar strength
Our election primer considers three key endgame scenarios for the election. We undertake the hard task of considering how markets may trade these outcomes based on current trends and pricing, and our own judgement of wider US dollar dynamics. In addition to this, we consider the prospect of a disputed election.
THE BLUE SWEEP: BIDEN WINS WHITE HOUSE, DEMOCRATS CONTROL HOUSE AND SENATE
Democrat control of the White House, Congress, and the Senate would usher in the strongest mandate for a centre-left policy platform since 2010. On balance, we believe this is the likeliest outcome, based on polling, political science predictions, and betting markets. Based on stated policy intentions, it seems likely a Biden administration and Democrat legislature would rapidly pass fiscal stimulus broadly along the lines of the current $2.2 trillion package that has already cleared the House of Representatives. In addition to this, longer-term increases to spending focused on infrastructure, climate, productivity and healthcare would likely be implemented throughout the year and possibly within the first 100 days of the presidency. This would keep fiscal policy strongly stimulative through 2021. The size of the additional spending under discussion is in the trillions, with proposed infrastructure spending alone reaching $2 trillion over four years. Additional housing, healthcare, education and social care proposals at least equal this total commitment.
Polling averages Show Biden with a substantial national lead
The other side of the Biden-Harris proposals is increased taxation, including increases in corporate taxes. The Tax Policy Centre has estimated that these revenue increases would total around $2.4 trillion over 10 years, with the burden falling substantially on higher income households and corporations. Tax subsidies for commercial real estate and fossil fuels are likely to be reduced, and additional subsidies applied to renewable energy.
Importantly, the distributional effects of the tax changes, as well as likely new spending on healthcare, would be strongly progressive.
Middle and low income households, which represent the bulk of consumer spending, would experience the smallest changes in percentage terms, while potentially benefitting from new spending in areas such as healthcare that are not directly included in taxation plans.
Biden’s proposed tax changes are strongly progressive
Aside from stimulus, the most important, and immediate effect of a Biden administration with a strong mandate would be a significant decrease in uncertainty regarding US trade policy. Depending on domestic pressures and the administration’s key appointments, there are reasonable prospects for a further lifting of US-China tariffs in a possible “phase two” trade deal. However, the wider trend of increased competition and economic decoupling between the US and China is unlikely to end under a Biden administration. Despite this, it is difficult to avoid the conclusion that US trade policy will be less erratic and less openly confrontational to existing partners in North America and Europe. In addition to this, US engagement with multilateral institutions is likely to increase again after a four year winter under the Trump administration, reducing the likelihood of sudden trade wars.
Global trade growth was already slowing prior to Covid-19 due to the trade war
HOW WILL MARKETS TRADE?
Looser, more progressive fiscal policy, combined with a less hostile approach to international trade both suggest a higher path for growth and inflation in the US. These two developments will contribute to a twin fiscal and current account deficit, while Fed policy will be notably more dovish than in previous recovery cycles. These are strong reasons to expect dollar depreciation. The Federal Reserve has clearly communicated its intention to maintain loose policy for much longer than previous recoveries, even in the face of substantial improvements in the labour market. On balance, these trends will reinforce our medium-term expectations for dollar weakness, during a US recovery that is characterized by loose monetary and fiscal policy, and may come chronologically later than many peer economies.
However, judging the short-term impact of a Biden administration requires balancing these longer-term drivers with the prospective relief of a smooth transfer of power and reduced uncertainty regarding US policy in general.
USD FX option term structures show markets bracing for an unusually sustained period of volatility after the election.
One possible interpretation of this is that market participants are pricing in the risk of civil unrest or a constitutional crisis. As this risk is removed, the dollar may enjoy a relief rally. Price action leading up to the result, as well as how long it takes for the result to be announced, will be important contributing factors here.
Additional thoughts and observations on a “Blue Sweep”
- The combination of stimulus and longer-term infrastructure and healthcare spending is likely to contribute to a higher growth and more inflationary environment in the US economy. Markets have treated this prospect as a negative for the dollar so far. Market pricing of a Biden victory, from betting markets, has traded with some correlation to the US 2-10 curve steepener – this is consistent with the idea that a Biden administration would implement curve-steepening, inflation-friendly policies. In a theoretical sense, loose monetary and fiscal policy, combined with a growing economy and rising inflation, are classic conditions for currency depreciation. So far this seems to be how markets are trading this prospect, although this may change in 2021 if it prompts a change in expectations of nearer-term Fed policy.
- However, in the longer-run higher inflation may eventually bring forward the first rate hikes from the Federal Reserve. At the moment this prospect is well outside the Fed’s forecast horizon, and market expectations, but could become relevant in 2021.
- With polls suggesting a Biden victory in any form is the likeliest outcome, spot pricing is arguably already partly reflecting the event of a Biden win and GOP Senate at a minimum. By comparison, the possibility of a contested election is arguably isolated to pricing in options markets, which by nature are used for speculative trades on events which may produce volatile outcomes. In this light, spot FX markets may only exhibit a minor USD rally, if at all, in the event Biden is announced as the 46th President and the Republicans retain the Senate due to the reduction of tail risk and uncertainty. While a Blue Sweep will provide more USD upside, the pre-emptive pricing in spot markets may limit the extent to which investors see a substantive dollar rally in this eventuality.
- The timing and size of tax increases will be important for the dollar, as will the size of a democrat majority in the Senate: with a strong mandate, tax increases could be plausibly pushed back to 2022, while progressive policy positions such as healthcare and climate will be easier to put into policy. A narrow majority may mean centrist Democrats will force more fiscal caution. Notably, some analysts have concluded that tax increases may lead to reduced corporate investment – we take no view on this at this early stage.
Steepness of US curve trades with some correlation to expectations of a Biden win
BIDEN WHITE HOUSE, GOP SENATE: WELCOME TO THE GRIDLOCK
Following the enactment of the Affordable Care Act and initial fiscal stimulus measures in response to the 2008 financial crisis, Barack Obama arguably failed to make major policy advances after the Democrats lost full control of the legislature in 2010. Republican control of the legislature ushered in a period of increased partisan discord and repeated crises over the debt ceiling. There is little indication that a Republican senate would be more accommodating of a Biden administration. Compared to the base case scenario, fiscal policy would likely be tighter, and less progressive, with a risk of budget-ceiling crises. A limited fiscal relief package would likely pass, but broader infrastructure spending would be doubtful. This scenario would be the likeliest upset of the current base case, as the polling errors required to produce it are relatively smaller, given the fact that key senate races are tighter than national presidential polling.
HOW WILL MARKETS TRADE?
A Biden administration hampered by a GOP senate will see its stimulus and spending plans greatly inhibited, lowering the growth outlook relative to base case through two primary channels. First, smaller and less timely stimulus in response to the current economic shock will risk a slower economic recovery, with greater scarring to consumer behavior. Secondly, Biden’s wider spending plans will likely fail, leading to tighter fiscal policy in the longer-run, although this will be offset to an extent by proposed tax increases also failing. On balance, this scenario will be less reflationary than the base case, and with a lower path for growth.
Our base case is that the longer-term outlook for USD would remain negative, and any relief rally upon Biden’s confirmation would be muted, if it occurred at all.
Donald Trump’s path to the White House in January lies in a closely contested election, possibly with a contested election being decided at the Supreme Court or in the legislature. There are two key scenarios to consider here: one with a complete Trump/GOP sweep, and one with partial Democratic control of the legislature. Partial Democrat legislative control would in essence be a status-quo outcome, and similarly to a Biden/GOP senate control scenario, would be characterized by partisan gridlock and less fiscal stimulus than our base case. However, a package along the lines of the 1.8tn-2.2tn currently being discussed by the White House and Democrats would likely be passed. A GOP sweep, in contrast, would likely also see further fiscal stimulus taking the form of tax cuts, although the distributional effects would likely be far less progressive than under a Biden/Democrat sweep. Trade policy would also likely be similar to the previous four years, although possibly with even less constraints on White House objectives.
Despite prediction models based on polls of likely voters generally predicting a Biden win, it is worth noting that Trump’s approval rating has been unusually steady when compared to other presidents.
This suggests that the coalition that originally elected him remains largely intact. Although the chances of a Trump/GOP sweep seem limited, the prospect most certainly should not be ruled out completely.
Trump’s approval rating is unusually stable
HOW WILL MARKETS TRADE?
Partial Democrat control of the legislature and a Trump white house is, in essence, a status quo outcome, and our existing base case for USD weakness would likely remain. However, uncertainty over trade policy would persist, potentially hampering a likely recovery in risk appetite in 2021. In the event of a GOP sweep, new and uncertain risks would be introduced to markets. Trump would have the threat of endorsing primary challengers in the 2022 mid-terms as a means of forcing compliance in the Senate. This would allow even greater power than during his first term, with relevance for trade policy, fiscal stimulus, and Federal Reserve nominations.
THE RISK OF A CONTESTED ELECTION
Uniquely among presidential candidates in recent history, Donald Trump has refused to commit to accepting electoral defeat, should reported results suggest he has lost the Presidential election. Instead, the President has repeatedly attacked the integrity of mail-in ballots, which will comprise a significant share of the total vote due to the pandemic. This raises a possibility that is almost without precedent: that the White House and Republicans will attempt to contest the result of the election and vote-counting, resulting in a disputed election and a possible constitutional crisis.
The Administration has several avenues for preventing the formation of a clear consensus that Joe Biden has won the presidency. These exist on a spectrum, which begins with relatively mild actions such as simple refusal to concede defeat based on incoming votes, statements attacking mail-in ballots, to “ballot security” operations by volunteers on the day of the election. Attempts to invalidate or restrict voting by mail, or the counting of such votes, is the next step on this spectrum – many such efforts are already underway in the courts. The President has repeatedly attacked mail-in voting, for example tweeting that main-in voting “will lead to massive fraud and abuse”. At the extreme end of the spectrum is the possibility of attempting to invalidate mail-in votes as they are being counted, possibly relying court motions. This strategy will rely on the “Blue Shift” phenomenon, where initial results from in-person voting favor Republicans, who are more likely to vote at the polling booth instead of by post. Later votes from mail-in ballots tend to shift the initial results towards Democrats. This may create an incentive to dispute the later results, or attempt to invalidate them.
These strategies depend in large part on a vote close enough for Donald Trump to be able to plausibly claim victory. If current opinion polling turns out to be replicated in the actual vote, particularly in swing states, these arguments may be moot as a clear landslide for Joe Biden limits space for dispute. If such space exists, disputes over battleground state results could continue as long as the deadline for appointments to the Electoral College on December 8th. Some of the most extreme, and unlikely scenarios involve state legislatures then directly appointing their members of the Electoral College, possibly ignoring or invalidating some ballots.
Markets participants have not ignored these possibilities. A recent survey of fund managers by Bank of America Securities found that 60% of respondents expected a “contested” election result. Similarly, volatility pricing from options markets shows an unusually large and extended dislocation in volatility expectations following the election. Judging the exact market reaction to the myriad possible scenarios and timings of a disputed election is impossible.
However, there are several points to make about the market impact of a disputed election:
- Initial results on the night of the election from polls conducted by media outlets will be hugely influential on the scope for a contested election result. A landslide Biden/Democrat win would likely see much of the uncertainty of a contested election immediately be priced out, possibly leading to a mild relief rally in the dollar. A closer than expected result, particularly in crucial battleground states, may immediately trigger a sell-off, particularly if these results are accompanied by attacks by Donald Trump on mail-in voting.
- If a contested election does ensue, it would likely be negative for the dollar, due to the risk of constitutional crisis and possible civil unrest. Due to the near-unprecedented nature of this scenario and the broad spectrum of possible dispute intensities judging the size of any losses is difficult. For some loose context, the DXY index of dollar crosses fell almost 9% from November’s highs to January’s lows during the contested 2000 election. The dollar has similarly performed badly during Government debt ceiling crises during the Obama presidency.
Term structure of EURUSD option implied volatility illustrates markets bracing for uncertainty…
EURUSD option implied volatility as of 22/10/2020
High expectations for sustained volatility following the election – stretching into December
EURUSD option volatility as of 22/10/2012
Front-end volatility was much cheaper than 2020, reflecting less expectations of volatility.
Author: Ranko Berich, Head of Market Analysis