To state the obvious, this week’s U.S. election will be, by far, the most important event, with a contested election looming as a key market risk. Earlier this month, Biden had a substantial lead in national polls, but his lead in battleground states has narrowed, increasing the possibility of a contested election.
From an economic point of view, this is a concern because a contested election delays much-needed stimulus and risks even greater economic damage to an already fragile economy. As it stands, consumers are already facing an income cliff, and funds for small businesses have also run out. On the state and local level, governments will likely be forced to cut jobs and spending if further fiscal support is delayed until after the inauguration. Regarding FX, a contested election should pressure cyclically sensitive currencies, with safe havens such as the Japanese yen and Swiss franc benefiting the most. The USD is also a safe haven currency, but gains from safe haven demand would likely be offset by fears of U.S. institutional stress.
The key question then is how likely is a contested election? At the time of this writing, polls show Biden ahead in all the battleground states except for Ohio and Texas. Additionally, Biden’s lead is larger than Clinton’s was at this point in 2016. But what if the polls are wrong? Keep in mind that state polls have a larger margin of error than national polls and that in 2016, Trump outperformed the polls in every battleground state except Nevada.
As an intellectual exercise, an analysis was done that applied the same state-specific realized polling error in 2016 to current polling numbers. Under these assumptions, Biden would still win, but the margin in Florida and Georgia would be less than 0.5% and would trigger an automatic recount. Additionally, the margin in Pennsylvania and Wisconsin would be ~1%.
To emphasize, this isn’t a projection of the results, but simply a hypothetical exercise applying 2016 data to current numbers. Of course, there are reasons why the polling error could be larger or smaller than in 2016. On one hand, pandemic-related issues could create a larger error term, but on the other hand, pollsters have adjusted their models to account for mistakes in 2016.
Again, this isn’t a call for a contested election or even a call for a contested election as the base case. It simply flags a contested election as a real risk. Back in 2000, it took until December 12 for the election to be settled, and only one state was contested. This time around, polling errors similar to 2016 could lead to several states being contested. With COVID-19 numbers rising and the possibility for uncertainty around the election outcome and further fiscal support, the markets could be in for a rocky next couple of weeks.
Regarding the timeline, election results will need to be generally finalized by Dec. 8 (Safe Harbor Day), as this is when states select their Electoral College (EC) voters. In 2000, this date was an important factor in the Supreme Court’s decision to stop the Florida recount. EC voters will cast their votes on Dec. 14, with the new Congress counting these votes on Jan. 6 and officially declaring a winner.
EURUSD weakened this past week as rising COVID-19 restrictions in Europe, ECB easing expectations and de-risking ahead of the U.S. elections outweighed positivity around a U.K.-EU Brexit deal. Given this, the currency remains within its long-held 1.16-1.20 range. On the monetary front, the ECB held rates unchanged as expected but did signal that economic risks were to the downside. This biased market expectations for further easing in December when new projections are due. Over the medium term, the dynamic of rising COVID-19 infections/increased lockdowns in Europe versus USD weakness driven by fiscal stimulus expectations should keep the euro range bound, although risks are rising for a deeper euro correction. Near term, the US elections and whether or not there will be a widely accepted result is the key currency driver.
Positive Brexit news continues 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 the deal 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. While the Bank of England shouldn’t cut rates, risks to growth makes other easing steps possible.
The Bank of Japan (BOJ) kept all of its policy setting unchanged and warned the markets about the risks of COVID-19 infections to the economic outlook. Ultimately the BOJ is taking a wait and see stance with a bias toward easing. Beyond monetary policy, overseas factors should continue to drive the currency more than domestic ones. Rising COVID-19 numbers 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. The bias remains to be short the yen as uncertainty around the U.S. election supports being long safe haven currencies near term while prospects for US fiscal stimulus/USD weakness provide yen support over a longer window.
The Bank of Canada held 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 US elections are important to many currencies, they are especially important to the CAD given Canada’s large trading relationship with the US. 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. Taken together, the bias is for commodity currencies to range trade with a bias for weaker as COVID-19 cases continue to rise.
Over the past couple of weeks, Chinese officials have signaled growing discomfort with yuan strength. While these steps may provide near-term resistance against further bets on yuan strength, the factors supporting continued currency appreciation remain. Relatively higher yields in China, COVID-19 outperformance and a current account surplus economy that continues to perform should warrant a bullish yuan stance. Of course, near term, the US elections are important given the significant trade policy differences between Biden and Trump. Both are expected to pressure China, but Biden should rely less on tariffs, which should reduce trade uncertainty in China and around the world.
Risks for the Aussie remain to the downside as AUD sensitivity to USD strength increases ahead of some potential risk aversion before the US elections. The Reserve Bank of Australia (RBA) also meets this week and is expected to ease. The bigger question is what happens to balance sheet expansion. News reports suggest that the RBA’s yield curve control program could be extended from 3 years to 5. Beyond monetary policy, Australia-China tensions continue to weigh on exports and overall market sentiment, and suppress additional investments such as mining companies pursing capex to take advantage of high iron ore prices. Overall a more dovish RBA and risks to exports from Australia-China tensions should both weigh on the AUD with the risk for consolidation due to its ~5.5% drop since early September.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to be cut 0.15% to 0.10%
Expectations for rates to remain unchanged at 0.10%
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to remain unchanged at 0.00%
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