Markets Not Pricing In Midterms' 'Tail Risk' That Could Roil U.S. Yield Curve

John Herrmann has a message for bond traders ahead of the Nov. 6 U.S. midterm elections: Beware the wave.

Most prognostications have a split Congress after next month’s vote. But Herrmann, a rates strategist at MUFG Securities Americas Inc., argues that a decisive result -- for either party -- has a higher probability than most forecast, and that such an outcome poses a sizable “tail risk” for the yield curve.

“In our models, there appears too much ‘complacency’ built into the financial markets base case assumption for the outcome of the midterm elections,” he wrote in an Oct. 19 note. “We do not recommend to clients to be ‘complacent’ in their market views ahead of the midterm elections, as a tail risk might emerge.”

While Herrmann didn’t predict a sweep for either party, he wrote that investors should be aware that one is possible. He predicts an election with a “fat tail” risk to the yield curve has a 37 percent chance, higher than he said current market pricing suggests.

A Democratic sweep of both the U.S. House of Representatives and Senate could lead to impeachment hearings, the exploration of tax increases, cuts to defense outlays and more social spending. This would contribute to flattening of the curve in Herrmann’s view, which is for economic growth to slow without further fiscal stimulus.

Conversely, if Republicans strengthen majorities in both chambers, that would lead to a “tactical” steepening of the curve, as Herrmann sees that infrastructure spending -- as well as more tax cuts -- could be on the way.

The bank’s base case for the curve is flattening between 2- and 10-year yields over the next 15-18 months as the Fed hikes by another percentage point by the first quarter of 2020.

The midterms are seen by some as a possible inflection point for the Treasury market. If Democrats take the House, congressional leaders could find common ground on infrastructure spending, and a Republican congress could propose more tax cuts. Either way, the end result would probably be more debt.

This article was provided by Bloomberg News.