What the hell is going on? Us midterms and crypto

It was a bad day for risk takers on Wall Street on Wednesday, with US stock indices incurring large losses. The S&P 500 and the Nasdaq were down more than 2% and the Dow was down 1.8% as volatility surged and haven flows boosted the dollar, the US dollar index rose 0.75%, and was the best performer in the G10. The drivers of the decline in risk sentiment were two-fold, firstly, it looks like the Republicans failed to win control of Congress. While they are expected to win the lower chamber, the House of Representatives, the Senate race is too close to call. At the moment, Republicans have 49 seats, and the Democrats have 48 seats. The goal is to reach 50, however, if both parties tie at 50, then the Democrats win the majority since the Vice President Kamala Harris has the deciding vote. Combined with a 14% drop in Bitcoin and the prospect of a major crypto exchange, FTX, collapsing in the coming days, there is plenty of drama in US markets this week.  

How Republicans lost the easiest election for them to win

Looking at the Midterms first, the Republicans did not do as well as the polls suggested, which is yet another sign that traders should not trust the polls. The Midterms are expected to have a high turnout, and Democratic voters, particularly women, came out to support their candidates in bigger numbers than expected. Some pundits are arguing that this was the easiest election that the Republicans lost. To put that into context, the incumbent New York Governor Kathy Hochel won re-election, after seeing off Republican challenger Lee Zeldin who campaigned on an anti-crime ticket after crime rates have surged across New York. The worse performance than expected from the Republicans has both political and financial implications. The political implications are that it won’t necessarily mean deadlock in Washington for the next two years, something that the markets traditionally like. Instead, it will leave the Democrats emboldened to push through some of their progressive agenda, which could impact the economy, including increasing corporation tax.

The Midterms and the US debt ceiling

A split Congress, with both the Republicans and Democrats in control along with the Democrats in the White House, could make it easier for the US legislature to increase the debt ceiling at some stage in Q1 2023. Ahead of this election, a big win for the Republicans could have led them to push for large federal spending cuts before they agreed to a debt ceiling increase. This could have led to a standoff in Congress, a technical US default and a shutdown of the Federal government services. However, this may have been averted. It also makes it harder for former President Trump to make a comeback for the 2024 Presidential election, since the candidates that he supported have generally not done so well in the Midterms. It is worth noting that not all of the Senate seats up for grabs have been called. There are three states that will decide who controls the Senate: the Arizona race is too close to call, Nevada and Georgia are also close. It is likely that Georgia will now have a runoff on 6 December, so it could take some time before we know who has control of the Senate.

Stocks and the Democrats: not a match made in heaven

The impact on financial markets is clear: stock indices would have preferred a win for the Republicans, who are seen as more pro-business. All sectors of the S&P 500 are lower on Wednesday; however, the energy sector has taken a large battering, and is down nearly 5% as the market increases the chances of windfall taxes on energy company share buy backs. Thus, as we move into the latter part of the week, there could be more losses for stocks. The markets had front-run the election results and stocks moved higher last week on the back of an expected win for the Republican party. However, now that does not appear to have materialised, then we could see some unwinding of this trade.

What does a divided House and Senate mean for inflation and the economy?

Inflation was the biggest issue for more than 30% of voters, which means that it will be top of US politicians’ minds as we lead up to the Presidential election in 2024. The Republicans want to limit Federal spending and cut taxes. This should have a relatively neutral impact on inflation (the spending cuts will be deflationary; however, the tax cuts could be inflationary), however, cutting spending into an economic downturn that is predicted for 2023, could exacerbate the recession that is already predicted for the US. The Republicans are in favour of drilling for more oil, while the Democrats would prefer green energy. Historically, a divided Congress has a limited impact in a recession, generally delivering late and limited fiscal support. Thus, while a divided congress is unlikely to limit interest rate hikes from the Fed in the near term, with the terminal rate expected to reach 5% in Q2 2023, there is a good chance that a weakening economic environment could cause them to cut rates more quickly than currently anticipated. 2-year yields barely moved on Wednesday, which is another sign that this result could lead to some recalibration of what the Fed will do in the second half of 2023.

When crypto blew up

However, it is disingenuous to think that the markets are as obsessed by politics as some analysts. Some will instead be glued to their seats watching the sharp selloff in crypto currencies, as one of the major crypto brokerages, FTX, is close to going under. Bitcoin has fallen 15% on Wednesday and is currently trading around $15,670. We have mentioned in recent weeks that a break below $20,000 is a bearish development that could trigger a decline back to $10,000. The driver for the second day of sell offs was news that Binance, another crypto exchange, had abandoned plans to buy FTX after the SEC launched an investigation into FTX’s business practices and the management of customer funds. While this investigation will come too late for some of those who traded with FTX if the brokerage now goes under, it could lead to greater regulation and scrutiny of the whole crypto space. Extra scrutiny from regulators is being prices into the market right now and could weigh on crypto currencies for some time. It is not too dramatic to say that the precipitous decline of FTX puts the entire crypto industry in jeopardy and it could have set it back from going mainstream for years, if not decades; and Fiat currency looks like it is here to stay.

The inflation report and the market reaction

E-mini futures are relatively flat as we move into Thursday, however, markets may remain directionless as we wait for Thursday’s October CPI data. The market is expecting the headline rate to deteriorate to 8% from 8.2% in October, and for the core rate to fall to 6.5%. This is unlikely to give the Fed much comfort as they weigh up the pace of further rate hikes next month. We will be watching the detail of the October CPI report closely, for headline CPI to fall then we will need to see a decline or pause in growth of prices for energy services and for food both at home and outside the home. For core inflation to fall in the US, then we will be looking for another decline in used car sale prices, along with declines in shelter costs (up 0.7% in Sept), transport services (up 1.9% in Sept) and medical services, up 1% last month. Without movement in these sectors, then inflation is unlikely to have peaked. A stronger than expected inflation report is good for energy stocks, although they could be hampered by prospects of a windfall tax from the emboldened Democrats. Overall, high inflation is bad for risk generally and for tech stocks, it is also good for the dollar and we could see an extension of today’s gains for the USD if inflation is hotter than anticipated.