Schroders: congressional gridlock may prove costly this time
This year’s US midterms look set to produce a divided government in Washington. Investors have historically viewed congressional gridlock as market-friendly, but that assumption may no longer hold, says George Brown
Midterm elections are often a painful reckoning for the party in power, with current polling suggesting the Republicans are unlikely to escape that fate. President Trump’s approval ratings imply the GOP could lose control of the House of Representatives, whilst the Senate is finely balanced enough that a Democratic sweep would hardly come as a surprise.
For investors, that would mean a return to divided government in Washington. Historically, markets have viewed such outcomes favourably. The conventional wisdom is that gridlock restrains policy risk, limits legislative surprises and reduces the scope for damaging intervention.
That assumption deserves re-examination.
An early flashpoint for the new Congress is set to be the debt ceiling, which on current projections is likely to be reached around mid-2027. In theory, preventing a default should be one of the few genuinely bipartisan issues in Washington. In practice, debt-ceiling negotiations have increasingly become vehicles for broader fiscal demands, creating episodes of brinkmanship that can unsettle markets even when a deal is ultimately reached.
The likely fault lines are already visible. Republicans want higher defence spending. Democrats want to reverse the administration’s cuts to Medicaid. Given the confrontational nature of fiscal negotiations in recent years, neither side may be willing to concede much ground. A last-minute compromise could therefore accommodate both demands rather than force either side to retreat. By our estimates, this could widen the deficit by around one per cent of GDP.
Two-stage risk
This creates a two-stage risk for Treasuries. Yields could initially fall after the election as investors price less near-term fiscal expansion. But they could reverse higher as the debt-ceiling negotiation approaches and attention shifts from legislative restraint to the cost of the eventual compromise.
The key issue is not the additional borrowing itself, but what it signals about fiscal discipline. If political compromise increasingly means larger deficits rather than fiscal consolidation, investors may demand a higher term premium to hold long-dated Treasuries, resulting in a structurally steeper yield curve.
Although we expect the likelihood of fiscal consolidation to remain low even under a divided government, markets are unlikely to reach that conclusion immediately. Instead, the dollar may weaken initially as investors judge that a lower likelihood of fiscal stimulus implies weaker growth and narrower rate differentials. But if Treasury yields subsequently rise, as we expect they will, the implications for the greenback become much less straightforward.
Historically, rising US yields relative to the rest of the world have tended to support the dollar. But not all yield increases are equal. Rises driven by stronger growth or higher rate expectations have generally been supportive. A rise driven by higher term premia and concerns over fiscal sustainability may have the opposite effect.
The question is whether foreign investors remain as willing to finance sizeable and growing US fiscal and external imbalances, while foreign allocations to US assets remain elevated. Even modest changes in investor behaviour could therefore generate meaningful currency flows.
If investors begin to demand greater compensation for fiscal risk, increase currency hedges or reassess their exposure to US assets, the result could be a weaker dollar even as long-term yields rise. In that environment, the dollar may provide less protection during downturns than investors have become accustomed to expecting.
Another variable to consider is how President Trump will respond.
Congressional constraints may see him pivot to greater use of executive authority, much as he did after Republicans lost the House in 2018. Trade policy is the clearest example, with Trump escalating his trade dispute with China in the second half of his first term, while criticism of then Fed Chair Jerome Powell also intensified. That led to a rise in both the VIX and MOVE indices as investors braced for greater volatility in Treasuries and equities.
Taken all together, investors should not view the midterms through the lens of directional trades. The greater risk may be a sustained increase in policy uncertainty, with consequences for Treasuries, the dollar and sector leadership within equities. Maintaining liquidity, avoiding excessive leverage and diversifying exposure across regions and currencies should leave investors better placed to absorb sudden shifts in policy.
The votes will be counted in November, but investors may still be counting the consequences years later.
George Brown is senior economist at Schroders