FX Market Voice: Does the Market Care Who Wins the Election?

The August FX Market Voice highlighted that implied volatility was being priced at historically low levels despite an array of seemingly major sources of risk. Not least among sources of uncertainty was a US presidential election which is shaping up as a highly unusual contest with substantial implications for the economy. Indeed, election uncertainty was already weighing on investment demand over the summer leading to some softening in the economy. The presidential campaigns have been contentious but the markets continue to take the election as a benign affair. As shown in the chart below, SPX 3-month implied volatility (VIX) did surge last month but this was due to concerns about Fed policy and had no apparent link with the election. With the Fed meeting in the rear view mirror, implied volatility is sinking back toward multi-decade lows. EUR implied volatility remains stable at two year lows; JPY volatility has been buoyed by uncertainty over Bank of Japan policy but here too it is trending lower, despite the looming election.

Exhibit 1. 3-Month Implied Volatility

Source: Eikon

Do elections not matter or is the outcome priced in?

There are two explanations for why the market seems so indifferent to the upcoming presidential election. Hillary Clinton has enjoyed a comfortable lead for the bulk of the campaign so the market may be heavily skewed on expectations of her victory and so not treating the outcome as a source of much uncertainty. Moreover, recent Reuters poll results indicate that equity market participants think that a Clinton victory would be good for the markets. But the other possibility is that presidential elections fundamentally are just not that important of a market event.

Exhibit 2. Clinton vs. Trump Polling Gap and 3-Month Implied Volatility

Source: Eikon

The chart above suggests that the closeness of the race does have some bearing on the perceived risk associated with the election; however, the impact is modest and fading. Both EUR and SPX implied volatility firmed in July when Trump closed the polling gap in the wake of the Republican Convention. And volatility subsequently eased as Clinton reopened the gap. But more recently, when Trump closed the gap in September, the impact on implied volatility was more modest – especially for the USD – and the impact of poll shifts on implied volatility seems to be growing more muted in recent weeks. The charts on the next page suggest that the market indifference in the election is justified by the historical lack of impact on market volatility. In election years from 1972 through 1988, realized SPX volatility did pick up on average in October, but the gain was slight and was only marginally above the 14.3% monthly average for this period as a whole. The chart suggests that there was a more significant volatility affect in the subsequent presidential election years. The financial crisis in 2008, however, is a distorting factor and when 1988 is eliminated the volatility picture looks roughly the same as in the prior period. For this year, there has been a firming of SPX volatility in September, but it is below the 15.3% monthly average since 1988 and the historical pattern suggests that the gain may be spurious.

Exhibit 3. Monthly Realized Volatility in Presidential Election Years

Source: Eikon

The picture is similar for realized USD volatility (using the DXY exchange traded dollar index) with some firming of volatility in October but not significantly above the 7.5% monthly average with the exception of late in the year for post 1988 data. But, here too, the numbers are distorted upward by the financial crisis

Does it matter which party wins or if there is an upset?

The table below gives an overview of the market’s response to each individual election. The candidates are shown designated by party (Red = Republican and Blue = Democrat) with the incumbent party shown first. The competitiveness of the contest is determined by the closeness of the polls and/or the absence of a landslide in the electoral split. Finally, there is an indication of whether Congress shifted control to the Democrats (D), Republicans (R) or Split (S). While the market rallied in both Reagan victories, it also rallied for Clinton and was split on the two George W. Bush victories; therefore it is not clear that a market bias exists for a victory by either party. 2000 was the most pronounced upset year as the election was very closely contested (anyone remember the hanging chads?) and control of both the White House and Congress shifted. Perhaps this is reflected in the biggest, save 2008 (more on this below), post-election market decline and a relatively weak dollar as well. 2008 was also somewhat of an upset year as the election was not a landslide and again Congressional control shifted. Here too, the market moved sharply lower following the election though again 2008 data was heavily distorted by the financial crisis. That said – the post-election USD decline was not a natural product of the crisis and may have been influenced by the election. It is also worth noting that shifts in Congressional control in non competitive years – 1980, 1982 – does not seem to have caused much market dislocation.

Exhibit 4. Election Specific Performance of the SPX and USD

Source: Eikon

It looks like a surprise would be bad for the market

Given her growing lead in the polls, it seems likely that declining implied volatility in part reflects the market fully pricing in a Clinton election victory. Historically, elections have not been major market-moving events. But the upsets in the presidential primaries and the more dramatic surprise result of the Brexit vote suggest polls may not be a reliable predictor of the outcome of the coming election. While it is a sample size of one, the negative market reaction in 2000 suggests volatility will surge in response to an unexpected result – especially in USD. As long as markets remain priced for a Clinton victory, volatility should remain modest. However, the potential for or the event of a Trump victory is likely to trigger substantial volatility.