How will the U.S. midterm elections impact financial markets?

The global financial markets may be impacted by the U.S. midterm elections.

For a long time, it looked as if politics had outlived its usefulness as a driver of exchange rates. But then came Liz Truss. Her incredibly short 44-day leadership of the UK Conservative Party, and the country as PM, set in motion the sort of volatility in gilts that we’ve hardly ever seen before – and sterling too was dragged down in sympathy. This might – thankfully – prove a one off but, in the US at least, President Biden is using it to his advantage by saying that Republican victory at the upcoming mid-term elections could give the US its own ‘Liz Truss moment’. Just how far off-beam is this claim? Or could it really happen?

Why would Biden make such a claim? The President is using the UK’s financial panic over Truss’s trickle-down economic fallacy to highlight the fact that many Republicans want to make the tax cuts enacted under former President Trump in 2017 permanent. These were widely thought to favour the wealthy and included changes such as cuts in corporation tax that tripped up the Truss premiership so badly.

Opinion polls suggest that the Republicans will win at least one of the Houses of Congress at the November 8^th mid-term elections. Most likely it will be the House of Representatives, where all members face the vote, rather than the Senate where only the usual one-third of seats are up for grabs. But even here there is a suspicion that the Republicans could take power with the Democrats only currently holding sway because of the casting vote of Vice President Harris. If the Republicans do make sweeping gains, by taking both Houses of Congress, for instance, will it plunge the US into a Liz Truss like political and financial market nightmare?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there seems to be at least three reasons why it will not.

The first is that incoming UK prime ministers have huge power relative to their US counterparts. Truss essentially tore up the Conservative Party manifesto that it used to win an 80-seat majority in the 2019 election by introducing her own version of trickle-down economics. If she had had the support of her own party members, she could have pushed this through. Of course, she did not have that support but the principal still applies that politics in the UK does not have the checks and balances that we see in the US and hence it seems very unlikely that a Republican takeover of Congress can usher in the sort of mad-cap economics that Truss was trying to introduce in the UK, and that so upset the financial markets.

The second point is that the ferociousness of the response in the UK gilt market to Trusseconomics was largely down to the fact that it caused an existential crisis for a certain section of the UK pensions industry which we have talked about before. The liquidity/solvency strains facing many providers of defined benefit pensions was clearly so great that the Bank of England had to temporarily suspend its plan to sell gilts and buy them instead. This being said, we don’t doubt that the unfunded tax-cutting budget of former Chancellor Kwarteng would have scared investors in gilts and the pound anyway. But the reaction was magnified many times over by this problem in the pensions industry and unless the US financial system has some sort of similar vulnerability, it seems very unlikely that markets will fracture in the same way as they have in the UK, even if Republicans can push through permanent tax cuts.

Thirdly, the US is not the UK in terms of its financial frailty. To see this just consider what happened to the pound at the time of the disastrous mini-budget. It collapsed to near parity against the dollar largely because these strained pension fund providers in the UK had to unwind currency hedges that they had used to extract higher global returns.

In doing so, they had large amounts dollars to buy back. This suggests that, even if some US financial institutions get themselves into a similar pickle, perhaps as a result of unnecessary fiscal largesse from the Republicans, their actions are more likely to make the dollar rise rather than fall as they too make a dash for (dollar) cash.