Don't read too much into knee-jerk USD move, Midterm results are 'no game changer'

A mildly bearish outcome for the dollar

As we mentioned in our midterms preview report, we see a Democratic clean sweep as a mildly bearish outcome for the US dollar, though not the instigator of a directional change in currency markets.

The key channel is fiscal policy. With Congress now in Democratic hands, Trump’s fiscally expansionary agenda is likely to be reined in, as lawmakers are unlikely to wave through further stimulus or tax cuts. Gridlock should confine negotiations largely to must-pass items such as the budget and the debt ceiling, putting paid to the passing of new legislation that could have further lifted expectations for US growth, inflation and Fed rates.

That matters because curbing new stimulus could partially ease deficit concerns and take some of the heat out of the Treasury sell-off, which has pushed yields to multi-decade highs in recent months. Lower yields would narrow the US rate advantage that has supported the dollar, while calmer bond markets could, in theory, sap the safe-haven flows that have also underpinned the greenback. The early reaction in markets fits into this reading.

The US Dollar Index fell by around half a percentage point during Asian trading hours on Wednesday as it became clear that a blue wave was on the way, though the 10-year Treasury yield has so far barely moved. There is precedent for this too, as when the Democrats won the House during Trump’s first term in 2016, the dollar drifted lower and yields eased as hopes for further tax cuts faded.

Why the dollar move should prove limited:

We would caution against reading too much into the initial knee-jerk move in the dollar, however. This is not a game changer for FX and ultimately we think that any downside will prove limited, largely for four reasons:

1. The outcome was largely priced in. A Democratic sweep was our base case and markets had firmly positioned for it: prediction markets had assigned north of a 90% implied probability of a House flip ahead of the vote and more than a 70% chance they took the Senate as well. The size of the Senate win may have been something of a surprise, but the outcome itself was not.
2. President Trump retains his veto, and Democrats are unlikely to reach a two-third majority in the Senate that is required to override it. This means that while Democrats can block Trump’s proposals for new spending and tax cuts, they cannot unwind the measures already in place - this acts as a fiscal brake, not a fiscal reversal.
3. Treasury yields look set to stay elevated regardless. We see little prospect of a material easing in yields in the near-term, which we think remains more a byproduct of higher energy prices, rather than necessarily fiscal policy. So long as the Iran war drags on and inflation expectations remain elevated this should keep yields high, supporting the dollar via rate differentials and maintaining its safe-haven appeal. A Democratic-controlled Congress could increase pressure on Trump to end the war, but it will not dictate US military or foreign policy.
4. The Fed offset. A Democratic Senate can stall Trump’s FOMC nominees, which should be dollar-supportive. The Senate must confirm each nominee to the Fed’s seven-member board, so Democrats can limit Trump’s ability to appoint governors who favour a lower fed funds rate, which may both ease Fed independence concerns and rein in rate hike expectations. The impact is small in reality, however, as few board seats are expected to open before the end of the term.

Not a game changer for currency markets

We don’t see the midterms as a game changer for our dollar view, and we would be wary of reading too much into the result for the greenback. We recently revised our dollar forecasts higher, partly on easing fears over institutional erosion, but more on the ongoing Iran conflict, the broader sell-off in bond markets and the Fed’s recent hawkish turn. None of those drivers changed overnight. Once the dust settles, we expect focus to snap back to macroeconomic news, starting with Friday’s nonfarm payrolls report for October. Congress may have turned blue, but the dollar’s main drivers have not.