The Mid-Term Dilemma

Americans head to the polls late on Tuesday in a vote that could lead to another deadlock in Congress but how the market will react isn't entirely clear. The British pound is the top performer for the 2nd consecutive day, while the loonie is the only loser against the greenback. The video for Premium subscribers previewing the various elections scenarios is posted below.

Rules of Thumb?

There are generally two rules of thumb for traders during elections: i) the stakes are overstated generally and in the aftermath of most votes the anxiety recedes and depressed assets tend to recover; ii) the immediate reaction rarely lasts (remember what happened immediately after Trump's victory was announced). Traders aiming to capitalize on volatility emerging on what are believed to be the exit polls or first round of official results will need to be swift in squaring/closing positions. Most importantly, remember to stay relatively small

The US midterm elections are primarily about the House of Representatives, with polls giving Democrats around a 70% chance of taking it back; which would give them an effective veto over major US legislation. That would result in a deadlock and a series of investigations that would undoubtedly infuriate Trump and further divide the US. Still, every election seems like a potential disaster in the leadup and businesses tend to get along just fine anyway, so risk assets and US stocks in particular are expected to rebound in time regardless of the result.

Yet rules of thumb don't always work. Italy earlier this year is a good example. The MIB index initially climbed 9% in the eight weeks after the election but has fallen 20% since.

Beware of November 2016 Moment

What's especially top-of-mind on the US vote is the results of the 2016 presidential election. US futures initially crumbled on the shock of Trump's win only to begin a turn the next day and an epic run for months ahead. Some said the reason to the subsequent rebound was the Trump's acceptance speech, which was surprisingly more concilatory and less divisive. By the same token, traders must watch not only the results, which will trickle from 5 am til 8 am GMT/London, but also the response (speeches) from the new majority/minority leaders in both chambers of Congress.

Could market participants anticipate a similar playbook? If that is so, then a Republicans win would trigger an immediate rally in stocks and selloff in the yen, and potential disappointment if they don't. Fundamentally, Trump is promising another tax cut so there's some underpinning, even if that promise rings hollow given the deficit concerns.

On the other hand, Democrats holding the House are much more likely to curb a trade war, which could also be good for markets. As for the US dollar, a Democrat win in the House would certainly curb Trump's ability to goose growth and that uncertainty is likely to weigh on the US dollar, especially if it means more aggressive trade policies since these are not the subject of Congressional approval.

While it's tempting to project certainty, the trade may be to chase the momentum once the dust settles. We will also be listening carefully to the responses from Trump, Democrats and Republicans to see if there's an indication of a willingness to work together.