Why the U.S. Midterms Won’t Rattle Bond Markets
Ahead of the U.S. midterms on Tuesday, polls favour the Democrats taking control of the House of Representatives, while the fate of the U.S. Senate remains less certain. The outlook for financial markets is cloudier still.
Analysts say investors should not expect a shift in Congress to materially affect the factors that drove U.S. 10-year Treasury yields sharply higher this fall, raising costs for Canadian borrowers as well.
Bond markets are likely to remain unsettled with the potential for government conflicts to lead to debt-ceiling brinksmanship and looser fiscal policy, amid uncertainty over the U.S. war with Iran, analysts say. For many investors, the best option may be to avoid major decisions.
“I don’t think having a high level of conviction or a strong view, given the heightened level of uncertainty from a macro perspective, is the right approach right now,” said Lorne Gavsie, head of macro and foreign exchange at CI Global Asset Management in Toronto.
“Anyone who has a very high degree of confidence may be humbled at some point.”
The yield on 10-year U.S. Treasury notes touched a 24-year high of 5.36 per cent in early October. Canadian government bonds were also caught up in a global rout, with the 10-year yield topping 4 per cent for the first time in nearly three years.
Bond yields move inversely to prices.
The run-up in U.S. bond yields in September reflected worries over the impact of higher energy prices on inflation, as well as a flood of government and corporate bond issuance, and concerns about the unsustainability of U.S. government finances.
Since then, rising investor skepticism over the outlook for artificial intelligence and technology companies has weighed on U.S. stocks, but bonds have staged a comeback. On Monday, the U.S. 10-year Treasury yield stood to around 4.9 per cent, while its Canadian equivalent yielded 3.75 per cent.
Ethan Currie, a strategist at National Bank, said a “decent amount” of the recovery in bonds reflected the safe-haven aspect of fixed income being “rekindled” on worries around AI.
“The bigger item for bond markets is whether or not we get risk appetite on a firmer footing, or if there’s more risk-off flow,” he said. “I think that has maybe a little more sway in the near term, coming out of the midterms, than the immediate fiscal impact.”
But given the role fiscal concerns played in September’s sell-off, a Democratic sweep could still bring them back into focus.
In a recent note to clients, Thomas Ryan, senior North America economist at Capital Economics, said Democrats trying to leverage debt ceiling negotiations to achieve policy aims raised the possibility of a debt default. Even in a less extreme case, Democratic attempts to push their priorities could lead to looser fiscal policy or the risk of an extended government shutdown, he said.
On the other hand, he noted that a Democratic-controlled Senate could bring comfort to investors by blocking President Donald Trump’s future nominations to the Federal Reserve, reassuring those concerned about the Fed’s independence.
Mr. Currie said he expected little to change in the event of a “blue wave” of Democratic wins in the House and Senate.
“On the legislative agenda it might be a bit of a speed bump for Trump, but I think it’s also important to note that this guy has worked through executive order more than any president,” he said.
With the President retaining significant control over foreign and trade policy regardless of the midterm election outcome, major changes in those areas are unlikely. This will continue to make his decisions on the U.S. war with Iran consequential for investors.
Serious de-escalation combined with a sustainable peace deal could lead to oil prices continuing to fall, Mr. Currie said. Global benchmark Brent crude dropped sharply on Monday, declining 7 per cent after Iran indicated it was open to peace talks.
But a return to escalation and a fresh rise in crude prices could bring inflation worries back to the fore and prompt a sell-off in bonds “in anticipation of higher-for-longer inflation,” he said.
Mr. Gavsie, who said he focuses on identifying market signals to drive investment decisions, said he would put the U.S. midterms “more in the noise category.”
“It certainly does not, at this stage, merit considerable changes from an asset allocation standpoint.”
This article was first reported by The Globe and Mail
