USD and the election: It’s the fiscal cliff, stupid

By:
Peter Garnham
Published on:

The dollar comes into a tight US election on the front foot, but that is more a reflection of concerns elsewhere in the world than the voting intentions in Ohio. That could be about to change.

The recent rise in the dollar index, and EURUSD for that matter, has been driven largely by heightened concerns over Greece and the future of the eurozone and expectation-beating US economic data, not whether President Barack Obama stays in the White House or Governor Mitt Romney moves into it.

Still as the vote gets under way the election is likely to have a greater impact on the FX market, especially as it will have a direct bearing on whether the US economy can avoid the impending fiscal cliff.

The perceived wisdom is that an Obama victory is bad for the dollar over the medium term, and the more fiscally conservative Romney good. Knee-jerk profit-taking of long dollar positions is therefore to be expected if Romney wins the race.

But beyond that, the dollar’s prospects are more nuanced.

While the focus is on who will be president, whether his party has control of the Senate, House of Representatives, both or neither, will be crucial in determining whether the fiscal cliff can be avoided, and thus the prospects for the dollar.

Current expectations of a slim Obama victory, combined with a Democrat-controlled Senate and a Republican-controlled House of Representatives, point to continued gridlock on the fiscal cliff.

That would be positive for the dollar, risking a re-run of the August 2011 debt ceiling crisis that led to heightened market anxiety and pushed the US currency 5% higher.

 USD benefits from August 2011 debt celing crisis (April 1 = 100)

 
 Source: ING, EcoWin

In contrast, a Romney victory in those circumstances would ease fears about the fiscal cliff, sparking a rally in equity markets and a sell-off in US Treasuries.

For the dollar, that points to losses against emerging market and commodity-linked currencies. Its sell-off against the currencies of developed European countries is likely to be milder, mitigated by the effect of higher US rates.

A Republican clean sweep of the White House, Senate and House of Representatives changes the picture. While it would greatly reduce the prospect of a fiscal cliff, it increases the chance of a change of leadership at the Federal Reserve.

The term of Fed chairman Ben Bernanke ends at the beginning of 2014. Romney is on record as saying he will replace Bernanke and is not a fan of the Fed’s quantitative easing programme, suggesting the new chairman might implement more restrictive monetary policy than "helicopter Ben" Bernanke.

In itself, the prospect of a more hawkish Fed chairman is positive for the dollar. But should a Romney victory prompt Bernanke to quit his post early, thus creating a policy vacuum and raising uncertainty in the market, that should prompt haven demand for the dollar and intensify any rally in the US currency.

There is plenty to ponder for FX traders; eyes down for the first exit polls at 19.00 EST tonight.