On Wednesday, the greenback was recovering from three consecutive days of rollbacks, while votes in the congressional elections continue to be counted in America.
Over the past three days, the dollar has declined by more than 3% against its main competitors, including the euro. During the same time, the S&P 500 index gained about 2.8%.
Market participants preferred risky assets amid increased confidence that Republicans would regain a majority in at least one or even both chambers of Congress in the midterm elections.
"The idea that the Republicans will regain the House of Representatives has caught on well in the market. We're not saying it won't be good for stocks, or we won't have a few pleasant days, or it won't provide some stability. But we think that in order for the S&P 500 to really rise, Republicans also need to regain the Senate," said strategists at RBC Capital Markets.
Apparently, investors were putting in quotes a scenario according to which the outcome of the midterm elections would be either a so-called "split government" (when the executive power is controlled by a Democratic president and the legislative power is controlled by Republicans), or a divided Congress (if Republicans gain control in the lower house and Democrats retain a slight advantage in the upper house).
It is assumed that such an outcome will have negative consequences for the dollar and positive for stocks.
According to RBC Capital Markets, the average annual return of the S&P 500 with a divided Congress is 14%, and with a Republican-controlled parliament and a Democratic president – 13%. The yield of the index under the full control of the Democrats is 10%.
According to experts, a possible political impasse in Washington may exclude US President Joe Biden's proposed increase in taxes on corporate income and wealthy citizens.
At the same time, the prospect of another dispute about raising the US debt ceiling is more important.
The Republican Congress can put an end to fiscal stimulus and make it a little easier for the Federal Reserve to curb inflation, FS Investments analysts say.
"If Republicans do get some power in the House and Senate, they could make raising the federal debt ceiling a really difficult process," Ingalls & Snyder analysts said.
US politics is once again becoming a burning topic in connection with the midterm elections. Republicans are on track to achieve a majority in the House of Representatives, while Democrats may lose the Senate. In this case, the shares may rise, which will harm the dollar, Credit Suisse believes.
"Although the final results of the midterm elections may be known only in a few days, it is highly likely that the Democrats will lose control of the House of Representatives, and possibly the Senate. This will lead to another phase of the "split government". We are inclined to believe that the likely result of such an outcome will be a strengthening of stocks," the bank's economists said.
"Since the growth of stocks also usually goes hand in hand with the weakening of the dollar, it is logical to expect that the strengthening phase of stocks associated with the midterm elections may damage the greenback," they added.
The political impasse in Washington will dispel investors' concerns about increased budget spending, exacerbating inflation, and increase the chances of the party freezing spending with the help of the debt ceiling. This will facilitate the work of the Fed, help stocks extend their recent growth, and also restrain the yield of US Treasury bonds and the dollar, analysts at Morgan Stanley believe.
Meanwhile, the unexpected victory of the Democrats, according to experts, will lead to an increase in the yield of treasuries, a strengthening of the dollar and will put pressure on stocks, since a possible budget expansion will require a greater increase in rates from the Fed.
Berenberg analysts believe that the election results will not have any significant impact on fiscal or monetary policy in the United States, and that the Fed's actions to curb inflation will continue to set the tone for the markets.
The S&P 500 index may fall by another 16% before it reaches the "bottom" in nine months after the Fed refuses to raise interest rates, UBS strategists say.
They expect that the slowdown in economic growth in the US will continue to pull stocks down until the second quarter.
According to the bank's forecast, in 2023, global GDP will grow by only 2.1% year-on-year, which will be the third lowest in the last three decades.
"Our forecast is approaching something like a 'global recession,'" UBS economists said.
"For the US, we now expect almost zero growth in both 2023 and 2024, and a recession will begin in 2023," they added.
According to experts, this economic downturn is likely to lead to a period of disinflation.
Given that the US central bank has quickly raised interest rates to try to curb inflation, which has reached a 40-year high, this would give policymakers the opportunity to switch to lowering rates to stimulate economic growth, according to UBS.
"In combination with the rapid fall in inflation, the Fed will reduce the key rate from the current 4% to 1.25% by the beginning of 2024," the bank's analysts said.
"The speed of this reversal will stimulate every asset class next year," they believe.
According to UBS estimates, expectations of a Fed reversal could raise the S&P 500 to 3,900 points by the end of 2023.
The bank also predicted that future rate cuts would cause the yield on 10-year treasuries to drop by 155 basis points to 2.65%, and the dollar would slowly fall against a basket of leading currencies.
US stock indexes showed a steady rise on Tuesday. Thus, the S&P 500 rose by 0.56% to 3,828.11 points. Meanwhile, the greenback fell in price against its main competitors by almost 0.5%, sinking to multi-week lows around 109.25 points.
The market's increased hopes that Republicans would gain a majority in the Senate and the House of Representatives allowed risk appetite to dominate financial markets, as a result of which the safe dollar lost demand.
Increased selling pressure on the US currency spurred the EUR/USD rally, as a result of which the pair reached the highest values in almost two months in the area of 1.0090.
However, on Wednesday, investors were forced to turn to the defensive dollar again, since there was no clarity as to who would control Congress following the midterm elections.
It is possible that the final results will have to wait a few days or even weeks, as it was in 2020.
As you know, markets most of all do not like uncertainty.
Key Wall Street indicators are trading in negative territory on Wednesday. In particular, the S&P is losing about 0.9%.
Meanwhile, the greenback attracted bulls and tested the area just above 110.
Amid renewed demand for the dollar, the EUR/USD pair lost its bullish momentum. Cautious market sentiment limits the pair's growth opportunities while investors wait for the final results of the midterm elections in America.
In addition, important data on consumer inflation in the United States are looming on the horizon, which will be published on Thursday.
Recently, the greenback has been under downward pressure from expectations that the Fed will soon abandon a tough rate hike cycle, possibly as early as December.
However, a surprise in the form of an increase in inflation may change this opinion and contribute to the strengthening of the US currency.
"The worst outcome for the markets will be core inflation, which will exceed expectations not at the expense of housing, which is easy to write off as a lag, but due to a wide range of rapidly rising prices in various categories. Given that expectations of a Fed rate hike by 75 bps next month have already been largely played back, there is a risk that such a surprise will force investors to re-evaluate at least a 50% probability of such an outcome, which will put pressure on risky assets and lead to a rise in the dollar," Credit Suisse economists said.
Markets interpret any weaker data in favor of a reversal of the Fed's policy, pushing EUR/USD up. However, Thursday's high value of the consumer price index (CPI) in the US may send the pair down, Nordea believes.
"Of course, the recent fluctuations in EUR/USD contradict our opinion about the upcoming strengthening of the dollar, but we believe that the recent price movements are more a reflection of tactical positioning, rather than changes in fundamental indicators," the bank's strategists said.
"The Fed has clearly stated that a pause in raising rates is not discussed as long as inflation is high. Fighting inflation means raising rates and even more pain for risky assets and the real economy. It seems that investors in the stock markets refuse to take this into account and interpret any softer data in favor of a reversal of the US central bank, which leads to an increase in risk appetite and a weakening of the dollar. Eventually, the situation should change, and investors will feel the pain again and remember the old adage: "don't fight the Fed," they noted.
"The US inflation report is the next key indicator in the short term. Higher-than-expected CPI data are a trigger for strengthening the dollar (6 out of 10 recent inflation releases this year), and this may well happen this week, especially if players hold a net short position on the US currency. In the future, EUR/USD is likely to continue its unstable dynamics, but we still adhere to our opinion that the pair will decline to the area of 0.9500 by the end of this year," Nordea said.
