The Market’s Pulse and Political Prognostications

With only three weeks remaining until the U.S. presidential election, traders have incorporated the prospective risks into their pricing strategies. Brian Garrett, a trader at Goldman Sachs, noted today that the VIX volatility index remains elevated—a rare occurrence when juxtaposed with the S&P 500’s record highs.

A Turn of Tides in the Electoral Race

Amidst this backdrop, the electoral tides have turned. The CICC team, led by Liu Gang, has observed a reversal in fortune; Trump has overtaken the previously surging Harris not only in betting odds but also in six of the seven key swing states, further complicating the electoral calculus.

The Index of Expectations

Goldman Sachs reports that their basket index betting on a Republican victory has soared to new heights, while the index wagering on a Democratic win continues to wane.

The Asset Impact of Election Outcomes

CICC posits that the success of the president in garnering congressional support, particularly from the House of Representatives which steers fiscal policy, will directly impact the feasibility of advancing relevant policies.

Scenarios Unfold

CICC outlines four potential scenarios:

• A Republican sweep (39%): A scenario akin to Trump’s 2016 victory, favoring the advancement of his policy agenda, particularly tax cuts.
• A Democratic sweep (18%): A repeat of Obama’s 2008 victory, which would likely ease the implementation of Harris’s fiscal policies.
• Trump + Democratic House (13%): Similar to the divided Congress post-2018 midterms, suggesting Trump may face challenges in fiscal policy but could pivot to trade policies via executive actions.
• Harris + Republican House (5%): Echoing the dynamic post-2022 midterms, indicating Harris may struggle with fiscal policy initiatives, potentially continuing Biden-era policies and administrative adjustments.

The Market’s Anticipated Reaction

CICC believes that the direction of asset impact, aside from the inherent differences in Trump and Harris’s policies, will also be influenced by the order in which policies are implemented. The probable direction is as follows: overall positive for U.S. stocks, though tariffs may negatively impact Chinese assets; a stronger dollar, neutral gold, rising interest rates; and commodity resources may benefit from Trump’s stimulus expectations.

Professor Gao noted that as the U.S. dollar strengthens, the interest rate differentials between the yen and the dollar grow, facilitating profitable arbitrage for investors. The Federal Reserve’s July inactivity but potential rate cut in September, as indicated by Fed Chair Jerome Powell, further fueled concerns over interest rate differentials. Some economists from international financial institutions, such as flagship groups, even predicted a 50-basis point reduction in U.S. interest rates in both September and November meetings.

In contrast, the European Central Bank, Bank of England, and the Bank of Canada have already reduced their rates, narrowing the arbitrage opportunities. Consequently, Japan’s monetary policy choice to raise interest rates signals the end of interest rate differential arbitrages. As the yen continues to devalue rapidly, Japanese financial institutions face pressure, balancing between maintaining stability in the yen’s exchange rate and addressing domestic market pressures.

Professor Gao emphasized that Japan must stabilize the yen to prevent major financial losses and uphold its credibility as a global safe haven currency. The depreciation of the yen has consistently hindered Japanese consumer purchasing power, while export profits from a weaker yen remain limited. Financial arbitrage institutions, both Japanese and international, stand to lose significantly if yen depreciation continues.

The return of arbitrage funds stabilizing the yen prompted rapid yen appreciation, soaring beyond 150 yen on July 31. As the yen surged, market concerns over additional margin calls or automatic liquidation heightened, leading to potential cascade effects. As a result, on August 6, the Bank of Japan announced that it would not tighten the market amidst instability, offering temporary peace to global financial markets. The swift rebound of the U.S. dollar to 146 yen triggered a similar reaction in the Nikkei and American stock indices.

There is ongoing debate among international financial institutions regarding whether the entire arbitrage positions have been liquidated. While some believe the yen short positions have mostly cleared, others estimate that only 50%-60% of the arbitrage trades have been unwound. Professor Gao concluded that the BOJ’s rate hikes caused financial shocks due to not just liquidity changes but also international markets’ deviation from real economic growth expectations. The shifts in financial market conditions and central bank policies over the first half of the year reflect Japan’s attempts to normalize monetary policy while attracting capital inflows to boost its domestic economy and stabilize the yen exchange rate. For Japan, the timing and rhythm of the rate hikes were primarily based on domestic circumstances, but their impact on the U.S. stock market exceeded expectations.