Where Goes Congress, So Does The Dollar
Democrats and Republicans are generally not associated with bulls and bears; but come election time, domestic and international markets quickly align themselves to the happenings in politics.  For recent examples one only needs to see the reaction in Japanese bonds, stocks and the yen when Shinzo Abe was elected Prime Minister in September.  Another politically triggered market jolt was stirred recently by UK Prime Minister Tony Blair’s announcement that he would step down within a year’s time. While both of these events have captured international headlines recently, most respectable news agencies around the world are now honing in on the US mid-term elections.  If history teaches us anything about this specific political cycle, US stocks, bonds and the dollar may be set for big moves ahead.

What’s at Stake in Congress?
On November 7th, Americans will head to the polls to determine the makeup of the two houses of Congress. This is important for the financial markets because it will determine whether we have a one-party majority or a divided Congress.  This could have very real consequences for the efficiency with which economic and trade-effecting policy moves through government. 

In the House of Representatives, all 435 seats are up for grabs which means that we could see major changes. Republicans currently control the branch with 230 representatives, or 53 percent of the House.  Democrats on the other hand, currently control 46 percent of the House,

In the Senate, there are 34 seats up for vote, which is a third of the 100-body senate.  Republicans currently control 55 of those seats and hold a comfortable majority over Democrats, who have 44 seats.  With only 15 of their seats up for grabs, Republicans need to win a lot less to maintain majority.  Democrats on the other hand, will need to secure at least 14 seats to be on par with the secure Republican holdings.  Republicans need a total of 60 seats to cut debates short and to override policy. The upcoming midterm election is important because there are enough seats up for grabs that partisan tables may turn. 

Who Is Ahead?
A recent opinion poll conducted by the Wall Street Journal and NBC News revealed ‘voters’ approval of Congress dropped to a 14-year low.  Suggesting the seas of change are almost upon us, 52 percent of those polled said they would rather see Democrats in control of Congress, versus only 37 percent of Republicans.  This was both the widest spread ever recorded between the two and the first time one group surpassed 50 percent.  Therefore the odds are in favor of a divided congress, which the markets may not take favorably. 

What to Expect from the Markets
Historically, the most important variable for investors when the ballot has been tabulated is whether one party controls both houses of Congress creating a state of ‘harmony,’ or if the nation is confronted with two years of “gridlock.”  Political gridlock is just as it sounds; Republicans hold majority in one house, while Democrats rule the other or vice versa, making it very difficult to pass sweeping legislation while keeping existing policy untouched.  Since this state of affairs is not conducive to the political process, it is also not beneficial for markets. Even though gridlock has been argued by the Wall Street Journal to be good for stocks, it may not be so good for the US dollar.  Foreign exchange markets like harmony and the chart below shows it.  Since 1982, every single mid-term election has been won by one party and in each instance except for one, the US dollar has rallied for three months after the election.   We define harmony as a time when one party has power of both the House and Senate. 

Taking a look at recent market reactions to even the less business-friendly periods of ‘harmony’ when the votes were in, the moves have been substantial. Following the Republican’s win of the House and Senate in early November of 1998, the EURUSD fell from 1.1900 to 1.1450 for 450 points in only three weeks time.  In the following twelve months, the extended move accounted for 1500 points.  The same level of volatility was seen in the most recent mid-term election in 2002.  In a matter of two weeks, the pair rallied from 0.9770 to 1.0140 for 370 points and eventually booked 2000 points after twelve months.  This level of volatility also has its roots in legislation.  Even though the two houses of Congress were in harmony during both periods, the rush by politicians to enact various bills to justify their worth to constituents led to large shifts in the US dollar that FX traders can jump on regardless of direction.

An Interesting Observation on the Fed
It is also interesting that in three of the last four mid-term elections, the Federal Reserve was in the process of shifting its interest rate cycle.  Whether this points to a political bias in the theoretically neutral Federal Open Market Committee or not, 2006 already looks to be the fourth such incidence.  In August, the policy group decided to cut its 17 consecutive interest rate hikes short in order to judge the lagging effects on inflation and growth.  With price gauges easing and the economy cooling with the housing market leading the way in the months since then, futures markets are already pricing in an eventual cut sometime next year.  Even if a cut is a long ways off, the plateau may be enough for the market to loose interest and focus on the outcome of a new Congress and its implications on domestic and international affairs.

Big Issues – Taxes and China
With history in mind, we now turn to some of the most pressing issues that will likely provide the momentum for capital markets after the election jitters settle. One matter that has been the subject of great interest for some time is the future of entitlement programs, especially Social Security.  President Bush has on a few occasions made a pledge to privatize the program that paid out nearly $500 billion in 2004, making it the largest government program in the world.  If such legislation was passed it would go a long way in relieving the long-standing fiscal deficit and possibly allow for further tax cuts which would be a double positive for the US dollar.  A healthier balance sheet and the possibility of tax cuts boosting consumer spending could also help to revive the economy.  However, this would likely require an undivided house, as the Democrats may block the removal of any large social program. Moving beyond the borders of the US, the composition of Congress could be integral in the future of the Schumer-Graham bill that has been batted around over the past year.  The proposal, if revived, would impose a 27.5 percent tariff on all Chinese exports as a means to encourage China to allow the Yuan’s exchange rate be determined by the market or otherwise move more quickly in loosening the controls.  Many, including Treasury Secretary Henry Paulson, say this protectionist agenda would damage international trade and scar foreign relations.  On the other hand, other politicians perceive it as an active way to bring down the nation’s record current account deficit, measuring $213.2 billion in the second quarter and bring jobs back to the US.  Similarly, gridlock would stall any hopes of this bill getting off the ground, as it is believed that Democrats would have to control Congress to push this bill through.

Conclusion
While politics seem to be something apart from efficient and unbiased markets, they obviously have substantial effects inside and outside the borders.  Whether the Democrats and Republicans split the houses may be less important than whether we have political harmony or political gridlock.  Furthermore, it is popular belief that the more business friendly policies of the Republicans would play out better for the US dollar.  Whether this is true or not, we will see in less than 3 weeks time.

Kathy Lien is the Chief Currency Strategist at FXCM.