For more on how the mid-term election may affect the markets see here
How Did the Markets React?
In the absence of any market-worthyUS economic releases, bonds, equities and FX were free to position themselves ahead of the unusual event risk inherent in US mid-term elections. The main concern with each of these markets comes with whether major opinion polls were accurate in forecasting the outcome and whether the nation is in for two years of political harmony or political gridlock. In periods of gridlock, one political party is in control of one of the two houses of Congress and the presidency while the other secures the other legislative division. Such conditions are ideal for debt and equity traders since it becomes much more difficult for bills that could increase taxes, or otherwise impact investment. Historically, these periods of gridlock have seen both stocks and bonds outperform. The implications for the US dollar are less clear cut. However, this time around, continued strength in domestic securities from a state of gridlock and the potential blocking of bills deemed unfavorable for trade (like the proposed Schumer-Graham bill to levy tariffs on all Chinese goods) could put a firm bid under a weak greenback. Though given the overall uncertainty of how the Republicans and Democrats will fare when the dust settles, volatility could be in store regardless.
Bonds 10 Year <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />US Treasuries
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Speculation underlying the outcome of tomorrows election was not as rampant in the bond market as it was in the benchmark equity indices today. Prior to recent shifts, media surveys showed the approval rate for the current Republican run Congress was at its lowest levels in 14 years, suggesting Democrats could be in a position to win one of the houses. However, recently this extreme sentiment has abated and debt securities are reflecting a more cautionary, wait-and-see tone. Opening near the low for the session, the face value of the note rallied consistently through the day for an 8/32nds gain to end floor trading at the 101-10 high. This was a modest move compared to the 20/32nds slide in notes in the minutes following Fridays NFP release. Nonetheless, the retracement in the face of momentum following the employment report from last week and the steady appreciation through the rest of the day suggests an outcome favorable to bonds when the vote is in.
FX GBP/USD
Traders pushed the US dollar higher against major world currencies ahead of upcoming elections. Though it is perhaps unclear that this reflects expectations of electoral gridlock, implied volatilities at or near record lows show that markets expect few surprises in the voting process. This is particularly pronounced in the EURUSD pair, as currency options currently show 1 week implied volatilities at a fresh record low. As the best predictor of volatile moves, these implied vols forecast currency prices within a very narrow range through the coming trading sessions. How this actually plays out will be particularly interesting for the GBPUSD, which remains just shy of 18-month highs of 1.9147. If tomorrows elections show any unexpected results?namely, a single party majority over both branches of the legislature?we could see substantive moves in dollar-denominated currency pairs. In fact, a dollar-bearish turn could lead the GBPUSD to challenge a significant price ceiling at 1.9150. On the flipside, continued gridlock could boost the US currency and send the GBPUSD off of its recent highs.
Equities S&P 500 Index
US stock markets stand to gain the most out of an electoral stalemate, as a mixed legislature would make it much more difficult to pass laws that challenge the status quo. Indeed, domestic equities have resumed previous strength on an unclear outlook for tomorrows elections. Todays rally could come to an abrupt end, however, if voting produces a decisive victory for the Democratic Party. Given that markets typically view the center-right Republican Party as pro-business, risks remain to the downside if their center-left counterparts win both the House of Representatives and the Senate in tomorrows elections. A Republican victory in the bicameral legislature would arguably produce the strongest reaction, but a political stalemate would likewise prove bullish for stocks. An even distribution of power would effectively prevent uncertainty over the future of fiscal policy?with neither Republicans nor Democrats powerful enough to challenge laws as they stand.
