Next year’s presidential election in the US may usher back in a period of uncertainty around the likely path for long-term monetary policy, Deutsche Bank’s Aleksandar Kocic writes, in his latest note.
Outside of recessions, presidential elections haven’t catalyzed much in the way of volatility across rates, equities and FX vol. (with the latter proxied by 1-month on EURUSD).
Prior to 2016, cross-asset volatility either fell or remained generally unchanged over the course of November in an election year, with the two exceptions being 2000 and 2008 “when recession was developing simultaneously with the elections”, Kocic notes.
(Deutsche Bank)
What accounts for subdued volatility around “normal” elections (i.e., elections outside of recessions prior to 2016)? Well, simple: Normally, the poles simply work to pull the center in one direction or another, according to the mood of the day.
“Traditionally, the path to victory in democratic elections is defined by defections between the left and right sides of the center”, Kocic writes. “The role of fringes is merely to re-center the center”.
Now, though, things have changed (and not just in the US, by the way). Instead of the center shifting slightly towards one fringe or another, the fringes now define the race. As Kocic puts it, “not only are the non-centrists shaping the narratives, but their proponents are emerging as the main contestants”.
It’s possible that western politics suddenly pivots away from the extremes, allowing centrists to reclaim the narrative, ushering in a return of what, until 2015, was the status quo.
As noted last week, that doesn’t seem likely. Kocic agrees. “Based on what we have seen so far, this is likely to persist through 2020 elections and possibly beyond”, he says.
If you assume that centrist politics will be on the back foot for years to come as right- and left-wing populists battle for votes, it’s reasonable to believe that bouts of volatility (perhaps especially in the rates space given the implications of their economic platforms for monetary policy) are in the offing.
Kocic goes on to recap the reaction in rates vol. following Trump’s victory and the bond selloff it entailed as the market priced in his pro-growth agenda and what that might mean for the Fed.
“The spike in volatility, triggered by the massive bear steepening of the curve in the 2016 post-election weeks, a consequence of expectations of an aggressive fiscal stimulus, was not only a gamma story”, he notes, adding that “the best performer was the 2Y2Y sector of the vol surface as uncertainty regarding the long-term monetary policy emerged as the biggest unknown in this context”.
Why was that the biggest unknown? Because when you pile debt-funded fiscal stimulus atop a late-cycle dynamic and then throw in tariffs, you end up with a lot more questions than answers when it comes to the reaction function for monetary policy which was suddenly forced to consider the possibility that the myriad structural factors weighing on inflation notwithstanding, deliberately overheating the economy and adding tariffs to the mix could lead to undesirable inflation outcomes.
And yet, nearly three years since the election, that uncertainty (around long-term monetary policy) has abated, even as Trump has managed to keep the pot around near-term Fed policy stirred. Here’s Kocic:
Despite tax cuts and continued spending in the public sector, the private sector remained in the saving mode, the effect of fiscal stimulus was neutralized by the Ricardian equivalence. When placed in the context of the global economic slowdown, Ricardian equivalence became reinforcing with its persistence perceived as a potential source of higher recession risk. There was an urgency to create a mechanism that would short-circuit this reinforcing loop, and monetary policy (driving rates aggressively lower) was perceived as a potential solution. Market thoughts were concentrated inside the near-term horizon with growing tensions regarding the immediate rate cuts, while concerns about the long-term policy remained on the backburner. The 2Y2Y sector of the vol surface collapsed not far from its all-time lows, while the term structure underwent a torsional twist with the front-end inversion.
Significant uncertainty around long-term Fed policy could easily reemerge around the 2020 election for obvious reasons.
With each passing poll, it appears more and more likely that the contest will be between two fringe candidates – Trump and Elizabeth Warren. Warren probably wouldn’t classify herself as a “fringe” politician, but compared to Biden she most assuredly is. Bernie is Bernie.
While both right- and left-wing populists (in this case Trump and Warren) advocate for fiscal stimulus, Kocic notes that “the two boundary outcomes have diametrically opposite views” on the mode for that stimulus and also on how the regulatory framework should evolve.
Trump’s fiscal stimulus (deficit-funded tax cuts for corporations and the wealthy) provided a sugar high in the form of higher stock prices and inflated corporate bottom lines, but to nobody’s surprise, his policies have not generated the kind of economic renaissance he envisioned. (Trump once asked Janet Yellen whether it was possible to engineer emerging market-like growth numbers in the US. She politely told him it wasn’t.)
“Based on what we have seen so far, the Republican mode has been conceptualized along the lines of tax breaks for the top echelon, which by nature has been fully Ricardian“ the bulk of the tax breaks have been saved, having a less-than-desirable impact on demand and growth”, Kocic observes.
That in part explains why the Fed has reversed course – if we’re all being honest, the tax cuts haven’t done a whole lot for the economy, and so the overheating Trump hoped to engineer never played out, inflation remained subdued and here we are looking at a third rate cut in three meetings. If Trump is reelected and can’t manage to deliver the kind of sweeping stimulus package he promised in 2016 (and will doubtlessly promise again), it’s possible we could continue along this path.
If, on the other hand, he does manage to get an infrastructure proposal (for instance) passed or cares enough about the middle class to cut the payroll tax or implement some manner of relief that isn’t squarely focused on top earners and corporations, we may eventually get to a place where the Fed has to make the “hard choices”.
(Deutsche Bank)
On the other side of things, Kocic writes that “in the case of a non-centrist Democratic victory, fiscal stimulus is likely to be more redistributive”. In essence, it will be a tax on savings, and depending on the quantum of additional fiscal spending, would “likely result in less deficit expansion than what we see on the Republican side”, he says.
In addition (and this is obviously crucial), Kocic notes that “redistribution would be non-Ricardian“ it would boost consumption and be more effective in terms of supporting higher demand”.
The outlook for Fed policy under a non-centrist Democrat is up in the air, as shown in the bottom of Figure 25.
As far as the regulatory landscape goes, the irony is that both sides (Republicans for less regulations and non-centrist Democrats for a much stricter regime), would work at cross purposes with their respective fiscal plans. “Stricter regulations would be effectively a negative supply shock leading to potentially higher prices and vice versa”, Kocic writes, adding that “this only complicates the post-election economic paths resulting in furthered dispersion in long-term monetary policy expectations”.
One way or another, record low 2Y2Y volatility likely underprices the resurgence of long-term monetary policy uncertainty that would presumably accompany any political outcome that doesn’t include a centrist victory. That informs a variety of trade recommendations in short-tenor vol. capturing the 2020 election.
Re: “Ricardian equivalence became reinforcing ”
I doubt that any economist can actually provide a real example of Ricardian equivalence — it’s sort of hazy and open to great debate.