Post-election, market consensus has shifted from a blue wave to a Biden presidency and a split Congress. In this regard, several news outlets have called the election for Joseph Robinette Biden Jr. but the final composition of the Senate will not be known until after the two runoff elections in Georgia this January.
Based on recent price action, markets believe that government gridlock combined with a dovish Fed should push U.S. real rates lower, risky assets higher and the U.S. dollar (USD) lower. Gridlock’s implication for the rest of the G10 is a bit more nuanced and will depend on the following: 1) Can the rest of the world de-couple from slower U.S. growth? 2) Can the Fed out-dove other major central banks? 3) Will gridlock lead to frequent cliff-edge policy uncertainty episodes that weigh on risk sentiment?
The most obvious consequence of a divided government is smaller fiscal stimulus than under a blue wave. The resulting weaker U.S. growth should be negative for the USD, but spillover effects matter too. Additionally, a divided government increases the risks for frequent cliff-edge uncertainty with government shutdowns and debt-ceiling debates similar to what happened in the early 2010s. Looking at historical data (2010–2013), here are some key takeaways for G10 FX.
Higher U.S. fiscal uncertainty was associated with Japanese yen and Swiss franc outperformance, as their funding currency use outweighed export exposure to the U.S.
Surprisingly, the Australian and New Zealand dollars also outperformed during this period of U.S. fiscal uncertainty. It’s possible that this result was due to other factors at the time, such as China. However, it is consistent with outperformance from countries with limited export exposure to the U.S.
The correlation to U.S. fiscal policy uncertainty for other G10 currencies was negligible. This includes the Canadian dollar, despite its large export exposure to the U.S. Commodity price strength, including oil prices, during this time provides some explanation for this outcome.
Trade policy also plays a role in FX with a divided government, as it is the area that can be addressed through executive powers that has the largest impact on FX. U.S.–China decoupling appears to be inevitable regardless of who is in the White House. What we have learned from the past three years is that tariff-based escalation tends to be associated with a stronger USD, while other forms of escalation (Hong Kong, tech listings, etc.) tend to have localized impacts. To the extent that a Biden administration focuses on alliance building against China, the U.S.’s trade policy should be more predictable, slower moving and less tariff-oriented. This, in turn, should reduce the USD's anti-cyclical demand.
Regarding other G10 currencies, they unsurprisingly have a negative correlation to trade uncertainty. A lower trade risk premium should then be associated with stronger currencies with the exception of safe haven currencies that should see less safe haven demand. Given this, it is important to remember that trade policy uncertainty has already dropped a lot with the Phase One deal remaining intact. So while a Biden administration could potentially reduce trade risk premium further, a lot of this may already be priced in.
EURUSD appreciated this last week despite uncertainty around the U.S. election, as markets looked through the possibility of civil unrest and serious legal challenges. Given this, the currency remains within its long-held 1.16–1.20 range. On the monetary front, the ECB signaled support for further easing at its December meeting when it would recalibrate its instruments, as appropriate, to respond to the unfolding situation, which skews to the downside due to rising COVID-19 infections and increased lockdowns. Over the medium term, the dynamic of factors both pushing and pulling the euro should keep it in its current range, but higher COVID-19 numbers, increased lockdowns and ECB easing argue that a break of this range should be to the downside.
Brexit remains the key near-term driver, with headlines continuing to support the pound as both sides work toward a deal by mid-November. Despite the market optimism, it is still unclear exactly how close we are to a deal. Nevertheless, given the multitude of issues unresolved and the short timeline remaining, a narrow deal appears to be the best-case outcome. While a narrow deal could help the pound move higher as it avoids the worst-case scenario, the gains should be limited, as a narrow deal still incurs economic costs, especially if it excludes large parts of the service sector, including financial services. Beyond Brexit, the U.K. also faces steep COVID-19 related issues, with data softening and COVID-19/lockdown restrictions rising. With the COVID-19 crisis far from over, further support is likely needed. In this regard, the Bank of England kept its policy rate unchanged at 0.1% in a unanimous vote but increased its asset purchases by 150 billion pounds, which was higher than consensus expectations. On the fiscal side, Chancellor Rishi Sunak extended furlough payments of 80% of wages to employees of shuttered companies until the end of March.
USDJPY continues to trade in the same range it has been in over the past couple of months. The view remains that overseas factors should continue to drive the currency more than domestic ones. Rising COVID-19 numbers, U.S. fiscal policy uncertainty and a pullback in outbound investment flows continue to provide support to the yen through safe haven demand and a reduction in what was an idiosyncratic source of yen weakness. Expect further range trading with a bias for yen appreciation.
On the monetary front, the Bank of Canada left its policy rate unchanged at its latest meeting. The main change was the recalibration of its QE program to include a tilt toward long-term bonds, which makes sense, as forward guidance already anchors short-term yields. While the U.S. elections are important to many currencies, it is especially important to the Canadian dollar given Canada’s large trading relationship with the U.S. As such, expect the currency to benefit should the Biden administration reduce trade uncertainty as expected. On the virus front, the resurgence in Europe put markets into risk-off mode and pushed WTI crude prices down to their lowest levels since June.
The Chinese yuan continues to perform despite Chinese officials signaling growing discomfort with yuan strength. While Joe Biden is expected to continue pressure on China, he is also expected to rely less on tariffs, which should reduce trade uncertainty in China and around the world. Relatively higher yields in China, COVID-19 outperformance, reduced trade uncertainty and a current account surplus economy that continues to perform should warrant a bullish yuan stance.
The Reserve Bank of Australia cut both its cash rate and its three-year yield target as expected. The bank also delivered a dovish surprise with its plan to buy AUD100 billion (~5% of GDP) worth of five- to 10-year bonds over the next six months and indicated that it was prepared to do more if needed. While U.S. Senate results are still pending, markets hold the view that a Biden administration and a red Senate will be a positive for stocks and thus a positive for the Australian dollar due to its correlation to the markets. On the virus front, Australia benefits from being in the Southern Hemisphere and is moving into its summer months. Should the country be able to control COVID-19 numbers, there is the potential for a period of economic outperformance. Regarding trade, Australia–China tensions continue to weigh on exports and overall market sentiment and suppress additional investments, such as mining companies pursuing capex to take advantage of high iron ore prices.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to be cut 0.25% to 4.0%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
U.S. CPI Month Over Month
Expectations for a 0.2% increase
U.S. Initial Jobless Claims
Expectations for a 725,000 print
EZ GDP Quarter Over Quarter
Expectations for a 12.7% increase
U.K. Unemployment Rate
Expectations for a 0.3% increase to 4.8%
U.K. Q3 GDP
Expectations for a 15.8% increase
German ZEW Expectations and Current Situation Survey
Expectations for a 44.0 and -65.0 print, respectively
Asia/Japan, and New Zealand
Chinese CPI and PPI Year Over Year
Expectations for a -1.9% and 0.8% print, respectively
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This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. City National Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.
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