US midterm elections: Implications for markets
The US midterm elections were tighter than polls indicated but key for markets is the still-likely change of control of the House of Representatives from Democrats to Republicans. Judging by the 2011 episode, a standoff over the US debt ceiling could upset equities and the Australian dollar.
The main relevance for financial markets in the US midterm elections is in control of the House. President Biden passed his signature fiscal packages on pandemic relief in 2021 (American Rescue Plan) and green energy, prescription drugs and health care package (the Inflation Reduction Act, previously known as Build Back Better) in 2022 using the Democrats’ House majority and 50-50 Senate where Vice President Harris casts the tiebreaking vote. In terms of delivering election pledges, only the 2022 infrastructure bill passed with bipartisan support.
A similar dynamic occurred under President Trump, with his legislation focused on corporate tax cuts passing in 2017, ahead of the Republicans being swept from control of the House in the 2018 midterm elections.
In short, while the Republicans’ apparent win in the House this year was much closer than expected, it ensures a completely different dynamic for 2 years from 3 January 2023. Like Trump, Biden can forget about any major new fiscal legislation that would increase a budget deficit running at a hefty 5.5% of GDP.
Gridlock on new spending, standoff on debt limit?
Bond markets may welcome a period of tighter fiscal policy which should reduce pressure on the Federal Reserve to raise rates further to cool the economy. What will be a lot less welcome is the high probability that a Republican-led House will generate standoffs over raising the debt ceiling and funding the government, potentially leading to shutdowns.
To be sure, a number of Republican House members (and in the Senate) publicly insist that they will not risk the debt default that would result from the limit not being raised in time. But many Republican representatives will demand a substantive quid pro quo for agreeing to raise the debt limit from its current $31.4 trillion. This could include cuts in social spending programs or demands to reverse some parts of the Inflation Reduction Act.
Of course, in theory, if the House Republican leadership wants to avoid default and upsetting markets, it could invite Democrats for support to pass a bipartisan debt limit increase. But this could infuriate the GOP’s base and many House Republicans.
Implications for the Australian dollar
The most obvious parallel is with 2011, when President Obama faced an emboldened Republican House majority. While a default was narrowly avoided, the multi-month standoff prompted S&P to cut their US credit rating from AAA to AA+ on 5 August 2011. Bloomberg economists estimate that a similar showdown in 2023 could cut US GDP growth by almost 1%.
The dramatic 2011 standoff reverberated around the world. A flight to safety sparked intervention by the Bank of Japan and Swiss National Bank to stem the surge in their currencies. The Australian dollar was extremely high in July 2011, around 1.10, bolstered by the gap between the RBA cash rate at 4.75% versus a Fed funds rate still at its post-financial crisis low of 0.25%.
But the turmoil generated by the US debt ceiling showdown spilled over to the Aussie, which tumbled 10 cents from above 1.10 in late July to around parity in mid-August. Of course there are always many differences in the macro environment, but the Aussie remains sensitive to bouts of risk aversion from whatever source.
Action in the lame duck session?
There remains one other possibility to avoid such drama in 2023 – with the Democrats still in control of both houses of Congress until 3 January 2023, they have an opportunity to pass legislation in the so-called lame duck session. There will be many competing priorities but voices including Senator Elizabeth Warren and the Washington Post editorial board have already called for the debt ceiling to be raised before Republicans take over the House. Such an outcome should be welcomed by equity markets and the Aussie dollar.
Trade and China – Same same?
One policy area that probably won’t change much with a Republican-led House is the US stance on China and trade more broadly. The Biden administration has so far made only minor reductions in the Trump administration’s wide-ranging tariffs. It has also expanded the range of restrictions on China’s access to US technology. There has been strong bipartisan support for the hard line on China and free trade is not seen as a vote-winner by either party.
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