Midterms: Fed Policy Impact

One question following the expected result in the midterms - how does policy respond to an economic downturn?

• The odds of getting an economic stimulus package to ward off a recession are more remote with a split Dem/Rep government.
• If the Fed were to be seen as being obliged to do the heavy lifting on policy easing where fiscal authorities fail to deliver counter-cyclical stimulus, it would be beneficial for rates and possibly negative for the dollar. But this time, the Fed is combatting a major inflation problem, and is unlikely to ease without significant evidence that inflation is coming down.
• Lack of both fiscal and monetary stimulus could imply bigger-than-usual downside economic risks. So if a slowdown does materialize, we could see a much flatter yield curve and a stronger dollar, with equities dropping further.

A Democrat sweep (only 10% probability priced) is the most negative scenario for Tsys and the most bullish for the USD.

• Not only is this outcome completely unexpected, fiscal stimulus going into 2023-24 would begin to look much more likely, particularly if the Democrats gain rather than lose seats – in an echo of January 2021 when their Senate win became known.
• This outcome would allow/force the Fed to tighten further initially. Even if the Fed is eventually given room to ease alongside stronger fiscal stimulus, long before that happens, signals of fiscal expansion would be likely to further bias Fed policy to the tight side.