The US Democratic Party won the midterm elections, causing significant volatility in global financial markets.
According to Xinhua News Agency on November 4, several mainstream US media outlets predicted that the Democratic Party won a resounding victory in the midterm elections held on the 3rd, regaining control of both the Senate and the House of Representatives. US public opinion believes that this midterm election has led to a dramatic change in the "power dynamics in Washington," putting President Trump in a "passive predicament with greatly reduced authority" for the last two years of his presidency.
The election results triggered a "massive shock" in the US capital markets. In the two trading days of the 4th and 5th, the US stock market first rose and then fell. By the close on the 4th, the Dow, S&P 500, and Nasdaq had risen by 3.03%, 1.58%, and 1.44%, respectively. By the close on the 5th, US stocks experienced a sharp decline, with the Dow, S&P 500, and Nasdaq falling by 3.44%, 4.36%, and 5.52%, respectively. The technology and industrial sectors were the "hard-hit areas," dropping 7.30% and 4.12% on the 5th, respectively.
International oil prices initially fell significantly before rising. By the close on the 4th, the price of light crude oil futures for December delivery on the New York Mercantile Exchange fell by 8.29%, and the price of London Brent crude oil futures for January delivery fell by 8.67%. By the close on the 5th, the aforementioned oil futures prices rose by 2.72% and 3.88%, respectively.
During this process, the US dollar showed a downward trend, falling by 0.3% and 0.02% on the 4th and 5th, respectively. US Treasury bonds rose, with the 10-year Treasury yield falling by 6.8 and 5.9 basis points on the 4th and 5th, respectively, to around 4.83%.
Why did the Democrats regaining control of Congress lead to such large fluctuations in the capital markets?
Analysts believe that with the Democratic Party controlling Congress, the Trump administration may face more checks and balances in pushing forward fiscal and tax policies. Meanwhile, the Democratic Party's stance on AI industry regulation and foreign policy may also impact the trajectory of the US economy and policies.
Looking at the longer term, how will these changes affect the dollar and the US Treasury market? Will it change the Federal Reserve's future interest rate decisions?
Weaker dollar, stronger US Treasuries
After the Democrats won the midterm elections, the market began to adjust its expectations for US economic growth, fiscal expenditure, and inflation. As the global currency and financial asset pricing anchor, both the dollar and the US Treasury market experienced fluctuations. The dollar index fell on the 4th and 5th, dropping to as low as 101.21, the lowest in a month. US Treasuries generally rose (corresponding yields fell), with the 10-year Treasury yield dropping to 4.814%, reaching a low not seen since September.
Regarding the performance of the dollar and the US Treasury market, Bai Xue, Senior Deputy Director of the Research and Development Department at Dongfang Jincheng, stated that the previous expectations for substantial tax cuts and infrastructure spending under the Trump administration were important factors supporting the strengthening of the dollar and the rise in Treasury yields. After the Democratic Party took control of Congress, the difficulty for the Trump administration to push for a new round of tax cuts and expanded fiscal spending increased, alleviating concerns about the further expansion of US fiscal deficits and Treasury issuance scale.
At the same time, the market is worried that increased regulation of the AI industry by the Democratic Party may affect technology company investments and data center construction, thereby dragging down corporate capital expenditures and economic growth. These changes have caused the market to lower its expectations for US economic growth and the Federal Reserve's maintenance of high interest rates, narrowing the interest rate differentials between US Treasuries and non-US currencies, thereby decreasing the dollar's attractiveness and pushing Treasury yields lower.
Hu Jie, a professor at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University and a former senior economist at the Federal Reserve, told The Paper that the dollar's short-term weakness is mainly due to the changing political landscape increasing market uncertainties, leading some investors to temporarily withdraw from related assets and adopt a wait-and-see attitude. The decline in Treasury yields is also related to adjustments in market expectations for expanded US fiscal spending. The checks and balances between the Democratic and Republican parties may increase the difficulty of passing large-scale fiscal spending legislation, thus marginally alleviating the supply pressure of Treasury issuance.
Jim Reid, Global Head of Macro Research at Deutsche Bank, also believes that "the divided situation between the two parties usually makes it harder for fiscal stimulus measures to be passed, and US Treasury prices have risen accordingly. This has somewhat alleviated concerns about the direction of fiscal policy." He also stated that investors expect the Federal Reserve to adopt a more dovish policy stance, with market expectations for the Fed's interest rate hike in June 2027 declining, which has also driven the dollar index lower.
AI industry regulation is another focus of the market.
The Democratic Party has previously been relatively cautious about the construction of large numbers of data centers. During the election process, the Democratic Party used this issue as one of the criticisms of Trump's policies. Therefore, after the Democratic Party gained more power in Congress, it may continue to take a relatively cautious attitude toward the development of the US AI industry. If the Democratic Party imposes certain constraints on relevant policies in the AI industry, the future demand for funds in this sector may weaken, thereby alleviating the funding competition with the Treasury market, Hu Jie said.
Stephen Brown, North America Chief Economist at Capital Economics, stated that the likelihood of increased corporate taxation and regulation of the AI industry has risen since the Democratic Party took control of Congress. Previously, some Democratic candidates expressed regulatory concerns regarding data center construction and its energy consumption.
Additionally, changes in AI industry investments may also indirectly affect US inflation through energy costs. Yang Zirong, Deputy Director and Associate Researcher of the Global Macro Division of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, believes that if stricter AI industry regulations lead to a slowdown in data center construction and related capital expenditures, the cost pressures from increased electricity demand may also marginally ease, thereby reducing inflationary pressures. This change may affect the market's judgment of the Federal Reserve's subsequent interest rate path.
“However, these factors are not enough to mean that Treasury yields will form a trend decline. Long-term Treasury yields are influenced not only by market expectations for the Fed's policy rates but also by factors such as term premiums. Even if the market lowers yields due to cooling expectations of fiscal expansion, if term premiums remain high, long-term Treasury yields may still face upward pressure,” Yang Zirong added.
Inflation expectations and oil price changes, will the Fed's policies shift?
"The retreat of fiscal expansion will suppress the additional rise in total demand, reducing the momentum for demand-driven inflation; the easing of the situation in Iran has brought oil prices down, directly alleviating input inflation pressures from the energy side. Together, these factors will accelerate the pace of inflation returning to target and reduce the necessity for the Fed to maintain high interest rates," Bai Xue stated.
After the midterm elections, international oil prices fell sharply. The market anticipates that with the Democratic Party controlling Congress, the Trump administration’s continued military actions against Iran may face more political and fiscal constraints.
Dennis Kissler, Senior Vice President and Trading Manager at BOK Financial, stated: "The Democratic Party's control of Congress may tighten US military spending in the Middle East and further increase the possibility of reaching a peace agreement soon." He pointed out that the increase in Middle Eastern crude oil exports and Trump's indication that there are currently no plans to attack Iran have intensified downward pressure on oil prices.
Hu Jie also believes that if the Democrats gain control of Congress and impose constraints on the Trump administration's relevant policies, which in turn affects US military actions and the energy market, it could theoretically have an indirect impact on inflation.
"However, this transmission chain is long and is unlikely to directly reflect immediate changes in the Fed's monetary policy in the short term. Moreover, even if relevant military conflicts end, oil prices and inflation will not return to normal immediately; they will still require a certain amount of time for transmission and adjustment," Hu Jie said.
Regarding the Fed's subsequent policies, he believes there's still a significant probability of a rate hike in December this year. Whether to continue rate hikes next year will depend on subsequent economic data. If the economic and inflation situations improve, rate hikes might not be necessary next year, but any cuts will likely have to wait until at least mid-next year.
Yang Zirong also believes that the Fed’s interest rate path in 2027 will be influenced by trends in energy prices. He stated that if oil prices only temporarily rise and then fall, and inflation expectations remain stable, it is highly likely that the Fed can start slowing rate cuts in 2027; however, if geopolitical conflicts keep energy prices high for an extended period and further transmit to core inflation and wage growth, the Fed may be forced to maintain restrictive rate levels for a longer time, and even face the possibility of monetary policy reversals.
Daleep Singh, PGIM Chief Global Economist, presented a different assessment. He believes that the Democratic Party's significant victory in this midterm election may create space for the Fed to further tighten monetary policy.
Singh asserts that the election results have weakened Trump's influence over Congress, US politics, and the Federal Reserve, giving the Fed more freedom to implement monetary tightening policies. He predicts that the Fed may raise rates four more times by the end of 2027, each by 25 basis points, pushing the federal funds rate target range up to 4.75% to 5.00%.
From the current market pricing, the election results have not significantly altered investors' assessments of the Fed's short-term policies. As of the time of reporting, CME FedWatch data show that the market still expects a greater than 70% probability that the Fed will raise rates by 25 basis points in December.
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