US midterms could reshape Dollar outlook

The US midterm elections - as we always say, the de facto referendum on the sitting president - are now less than four weeks away, and the Democrats look well placed. Nate Silver’s widely followed forecast model currently shows a lead of almost 10 points for the Democrats in the generic ballot, while President Trump’s net approval rating has slumped to -22.

We broadly agree with prediction markets, and see around a 60% chance that the Democrats take both chambers, a 30% chance that they win the House but fall short in the Senate, and just a 10% probability that the Republicans hold on to both. The House looks a fairly safe bet for the Democrats, and while the Senate appears a tougher hill to climb, our base case is that they win outright there as well.

With political paralysis, i.e. a divided or Democratic-led government, largely priced in by markets, the reaction in currencies to the midterms could be relatively contained. A Democratic clean sweep would likely be good news for the deficit at a time when fiscal worries are rattling bond markets worldwide, and the dollar could weaken modestly if this eases fears over debt issuance.

We think a Democratic House alongside a Republican Senate would have a similar impact on the dollar, though the budget infighting and debt ceiling brinkmanship that would follow could add to volatility.

A Republican hold on both chambers is the real tail risk, as this would likely mean more spending, possible tax cuts, wider deficits and higher Fed rates. The dollar's reaction would be hard to call, but our instinct is that it would rally as markets price in more aggressive Fed hikes. Again, this is our abridged view - be sure to look out for our full midterms preview report in the next few days.