Let’s get started…
US Election Playbook
The US election day is finally upon us. In this article, I will touch on the most essential snippets of information that as a trader you must take into account as it relates to financial and market risks. It is no secret that the outcome of the US election and most importantly and the different combinations of outcomes will create huge spikes in volatility, so as traders, we must be prepared for it.
So, let’s visit the first pressing question as a trader you may have. At what time is the volatility likely to ramp up? Based on the composition of the voting system and the timing of announced results per state, it won’t be until at least 3pm AEDT (Sydney time) on Wednesday that the market will really start to come to life as to corroborate or start to negate the head start that Joe Biden has got in the opinion polls, which points at a relatively comfortable victory of the Democrat candidate.
It’s typically around that range of 3pm to 3.30pm AEDT that a key swing state such as North Carolina could move the needle to clear up whether or not Biden is headed for a win or Trump can challenge him. Another key state that at a slightly later time will also play a huge role includes the state of Florida, with a tendency too report quite early. The more the market finds out what way the balance tilts in the key swing states, the more conviction of movements we’ll see.
As the volatility increases, be reminded that a major market risk one must account for and accommodate accordingly as part of one’s trading strategy will be the widening of spreads. As a result, traders should adjust stop loss orders in line with these unfolding dynamics. This phenomenon of spreads widening will occur as a result of higher than normal volatility but can also occur as as a byproduct of low liquidity, which won’t be the case around the US election. The bottom line is that as a trader, you must be able to anticipate this tremendous increase in volatility in order to adjust the size of your trading positions, the risk per trade and the type of risk management you consider. Failing to do so can significantly increase the financial risks markedly.
Another risk that I’d add within the category of market risk around the outcome of the US election includes the yo-yo/whippy type moves with multiple shifts in directional bias within a relatively short span of time as the market figures out the most plausible scenarios. It’s going to be hours of frenzy and most likely two-way street price action which means the market will hardly make up its mind and go straight into one direction right off the gates but instead dynamic swings in both directions should predominantly dominate proceedings until the market can assert with a sufficient degree of confidence that a specific outcome is a near certainty. Note, the more confidence in a concrete result (blue wave, Trump victory, etc.), the more conviction by the real money (non-leveraged funds) to enter the market and create the real trends that last.
An added element of uncertainty this time around is the fact that given the huge numbers of in-mail voting due to the global pandemic, the risk of the US election results in certain key states being contested is an additional risk factor not to be ruled out. If any of the candidate were to go down this route, the uncertainty may drag on and with it the looming clouds of risk-off dynamics. There’s actually been a growing school of thought that an actual sealed outcome alone may be a stimulant for markets to rally. In this election in particular, there is definitely an increased number of variables one must account for. Hence, more than ever, keeping one’s eyes not just to price action but to Twitter feed and TV networks for breaking news can be helpful. Do not take for granted the first movers’ advantage even if it’d be right away manifested via price action.
By looking at the implied volatility in some of the major pairs in Forex such as the EUR/USD, GBP/USD, AUD/USD or USD/JPY, the implied market movements range from 200-250 pips in lower vol pairs such as the Euro or Aussie vs the USD to as high as 400 pips in a pair like the British Pound against the USD. Again, playing with your normal stop loss size when the volatility to be expected is so high would be a suicidal strategy to adopt. Stay dynamic and adapt to the ebbs and flows.
With the above elements to consider out of the way, what’s the consensus market reaction based on the different number of combinations? Let’s analyze the scenarios:
This outcome refers to Democrats taking control of both the House and the Senate. I’d consider this one to be the most market-friendly outcome given that it implies a strong government would be in place with the ability to pass policies without major hiccups or obstructions unlike what we’ve seen in the last 2 years, which based on opinion polls and better markets appears to be the most likely scenario even if the odds have been narrowing. What this outcome would mean is an almost immediate fiscal stimulus package alongside high spending and deficits. In FX, the US dollar and the Japanese Yen should take a back seat in benefit of commodity-linked and emerging market currencies with the Chinese Yuan and the Mexican peso set to thrive. This scenario would likely be music to the ears of perma bulls in Gold amid broad-based USD weakness and further stimulus. Stocks would also fly. The intensity on how hard these assets run higher may also depend on the margin of victory by Biden in the Senate.
This scenario is one that I’d personally see as quite possible even if betting sites are telling us it is not as high odds as a full-blown blue wave. The consensus assigns a negative reaction in risk dynamics should both parties have a split of power in the House vs the Senate. A Republican majority in the Senate means that any Biden legislative initiates would get almost immediately blocked. Besides, in the short run, a large fiscal stimulus package would be complicated. Expect the US Dollar and the Japanese Yen to go one way (up) and stocks to head in the opposite direction with the allure towards commodity-linked currencies (AUD, NZD, CAD) compromised too. The price of Gold may also see a bearish movement mainly driven by the run to the safe haven appeal of the USD even if the precious metal should still be bid across a wider range of currencies on risk-off flows.
If Trump takes control of the House and the Senate it means less stimulus – not the $3tn Heroes Act – The fact that Trump will go back to policies of US exceptionalism, further deglobalisation, and remove fears of regulations or taxation is likely to lead to a strong reaction to the upside in both US stock valuation and the US Dollar. I can envision nominal yields down and real yields more negative with gold also jumping higher and the Yen put under strong pressure amid the rise in equities. The reinvigoration of Trump in the Senate will see him return to the strong rhetoric against China and Russia, which would tend to be negative for emerging markets and spark USD demand. I don’t see the Aussie doing that well in this environment near-term. This would also be the worse scenario for Gold near term.
This outcome would be a repeat of what we’ve seen in the last 2 years with a gridlock to pass new legislative measures, which has been well exemplified via the constant back and forth to ink a pandemic-led fiscal stimulus deal. On this outcome, the fiscal support eventually agreed won’t be as big as the market initially hoped for. I can see how under this scenario of divided powers in the House vs the Senate, equities would come under pressure as the market flocks off to places such as the US Dollar and the Japanese Yen. The price of Gold would likely be suppressed by the strength in the US Dollar. The fact that this outcome also equates to think about further deglobalisation should see the Chinese Yuan impacted by depreciating quite strongly.
In this video analysis below I dissect the information above with more visuals. The video is intended as educational in nature and not financial advice.