US midterms put fiscal policy under the spotlight, treasury sell-off raises risk

The US will hold its midterm elections - a de facto referendum on the Trump administration - on 3rd November after two years shaped by rising trade protectionism, attacks on Federal Reserve independence and, since the spring, the Iran war. Republicans are expected to take a heavy electoral hit. A meaningful share of their voter base opposes the war and has never been given a convincing enough justification for it - not least as one of Trump’s central campaign pledges was to keep the US out of new conflicts.

The economic fallout has also worked against the incumbent president and his party, with rising inflation and higher interest rates deepening the affordability crisis. Against this backdrop, Democrats are expected to make substantial gains.

For markets, the most important implication of the elections will be the impact on fiscal policy. Given the broad sell-off in Treasuries in recent months, which has pushed yields to multi-decade highs, we expect the midterms, and their potential impact on fiscal policy, to take on added importance and face more scrutiny than usual, raising the risk of an amplified market reaction, including in FX.

We see no real signs of pre-midterm jitters in markets so far. 1-month implied volatility in EUR/USD rose in late September, though we see this as a broader move attributable to developments in sovereign bond markets rather than any idiosyncratic political fears.

Treasuries have, of course, sold off sharply in recent weeks, though again we view this as largely due to inflation concerns, while the S&P 500 has roared to fresh record highs this month, seemingly ignoring the political and geopolitical noise.