The U.S. Dollar: Why the Midterm Elections Will Set the Agenda for Currency Markets From Here

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- USD edges higher as crucial midterm election ballot approaches.

- Vote a de facto referendum on Trump, which is significant for USD.

- Could bring electoral gridlock, growth slowdown and impeachment. 

The U.S. Dollar shifted onto its back foot Tuesday ahead of a series of Congressional elections that many analysts say will set the trend for the greenback, and all of the global currency market, into year-end and beyond. 

Some have labelled Tuesday's midterm elections as a referendum on President Donald Trump himself.

And to a certain extent they are right, because the stakes are so high the outcome of the elections could be the difference between whether the opposition Democratic Party is able to impeach the president or not. 

All 435 seats in the House of Representatives and 35 of 100 Senate seats will be up for grabs in the ballot taking place on Tuesday. 

Most polls suggest the Democrats will retake the House of Representatives, leaving Congress split down the middle, as the Republicans are expected to retain control of the Senate. 

"Most analysts believe that scenario will see the dollar and US rates dip on the view that chances for any further US fiscal stimulus are curtailed. That is seen as a positive for those emerfing market currencies undone this year by higher US rates," says Chris Turner, head of FX strategy at ING Group. "A Democrat Blue Wave of a win in both chambers might be tougher for the risk environment, where the market would turn to the politics of impeachment." 

The Dollar index was quoted 0.03% lower at 96.28 Tuesday and is now up 4.3% for the 2018 year. 

The Pound was 0.13% higher at 1.3074 against the Dollar but is down -3.1% in 2018 and the Euro was up 0.03% at 1.1412 and has declined 4.8% this year.

Above: U.S. Dollar index shown at daily intervals. Captures 2018 performance.

"A divided Congress should support our outlook for the US dollar as measured on a DXY-basis to weaken by 5-10% in the year ahead. US dollar weakness should start to become more evident in 2019," says Lee Hardman, an analyst at MUFG

Hardman says the U.S. Dollar response to a Democract victory in the House should be limited because markets are already anticipating the outcome, but that it would add to the case for weakness in the currency next year. 

A Democrat victory in either the House of Representatives or the Senate Tuesday would necessitate a process of horse-trading before any future legislation can be moved through Congress. 

This would complicate efforts to lift the so called debt ceiling on March 01, 2019, which is the date at which the latest suspension of the borrowing cap comes up for renewal, raising the spectre of another "government shutdown". 

It would also make a second round of tax cuts and reforms much more difficult to move through Congress, while rendering efforts to repeal unnecessary regulations and reduce red tape for businesses all but impossible.

"Of course polls have been wrong before, thus should the Republicans surprisingly hold Congress, the dollar, equities and Treasury yields would get a lift on the promise of Trump 2.0," says ING's Turner.

Still, the same pollsters who say the Democrats will retake the House also said President Trump was not going to win the 2016 election.

Some even said, back in 2016, Trump's chances were "approaching zero" and that Hillary Clinton had a "more than 99% chance" of winning the presidency

"We find that a surprise Republican victory in the House (218 seats wins majority) will likely lead to a 2% appreciation in the trade-weighted USD," says Bipan Rai, a macro strategist at CIBC Capital Markets

Above: CIBC Capital Markets estimates of USD response to Republican victory.

Rai and the CIBC team say if the Republicans were to surprise markets by retaining control of the House the Dollar would be a big beneficiary.

The above table shows the odds of each G10 currency falling by 1% and 2% against the greenback in the week to Wednesday 14 November if the Republicans win. 

"The strength of the US economy combined with President Trump delivering on key election pledges could result in the Republicans performing better than expected in the mid-terms. It is an outcome that poses upside risks to our US dollar forecasts for the year ahead," MUFG's Hardman says.

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Why it Matters for the Dollar 

Midterms matter for the Dollar because, despite all of its controversy, the Trump administration's tax cuts have been key to the greenback's 2018 renaissance.

The Trump tax cuts were a form of fiscal stimulus that has driven a pickup in U.S growth at a time when other economies have begun to slow.

That enabled the Federal Reserve to go on raising its interest rate while other central banks sat on their hands, helping the Dollar index convert a 4% first-quarter loss into a 4.6% 2018 gain in recent months.

Therefore, a Democrat victory would undermine the odds of another stellar performance from the economy and U.S. Dollar.

"Polling into the US Midterm elections suggests rising odds of a divided government, and the assumptions of risk off that would drive on the back of gridlock," says Richard Kelly, a strategist at TD Securities. "Polls have not been kind to traders in recent years."

The TD Securities team flag a heightened level of uncertainty around the current polling numbers because, as much as they still point toward a Democrat victory, Kelly says there are individual surveys showing some races as a "toss up" when those seats should be leaning firmly toward the Democrats. 

The electoral gridlock that could follow a Democrat victory is why most analysts say such an outcome would have a negative impact on the Dollar. But that likely gridlock could eventually be made worse if the opposition party acts on its oft-cited desire impeach Donald Trump

"The issue of impeachment and removal of the President is regarded as very unlikely," says MUFG's Hardman. "Although only a simple majority is required in the House to initiate impeachment, a 2/3rds supermajority in the Senate is necessary for removal."

Opposition politicians and broad swathes of the media have regularly pondered aloud the prospects of impeachment ever since the November 2016 election.

The U.S. constitution gives the House sole power to impeach a president through a simple majority vote although the subsequent trial has to be carried out in the Senate and requires a total of 67 out of 100 votes to convict.

As a result, Tuesday's election could give some in Congress the power they need in order to set the ball rolling on the impeachment process, which would create a significant distraction for the Trump administration. This would be even worse for the Dollar. 

However, without control of the Senate chamber as well, the Democrat's case for impeachment would have to be a strong one for them to secure a conviction. It's far from certain that there is even a case to be answered, much less a strong one. 

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