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If Trump gets his midterm wish, interest rates could go even higher

Key Points
  • The consensus midterm election outcome for a Democratic win of the House and a continued Republican majority in the Senate is not likely to change the outlook for interest rates, but a surprise Republican hold of the majority could mean higher rates.
  • Strategists say Republicans could seek more tax cuts and increase the deficit as a result, with more debt issuance driving interest rates higher, but they also could create more growth, also a driver of interest rates.
  • The Fed is likely to stay on course no matter what the election outcome, but if there is a big upset and Democrats win both houses, one strategist said President Trump may be slightly less inclined to criticize or challenge the central bank.
House Republicans are sworn in, during a session in the House Chamber January 3, 2017 in Washington, DC.
Getty Images

If President Donald Trump gets his wish and Republicans hold Congress, he may also get something he doesn't like — even higher interest rates.

The view in the bond market has been that a GOP Congress would be more likely to move forward with making the individual tax cuts permanent and boosting stimulus spending — two things that could make the already expanding budget deficit even larger. That means more debt issuance by the Treasury, and that's a negative for bonds. Yields would then rise as bond prices fall.

"A Republican-led Congress could introduce more tax cuts, leading to higher budget deficits, more issuance of U.S. Treasuries — and potentially higher bond yields. Republicans may seek to extend the life of individual tax cuts and try again to repeal the Affordable Care Act," wrote BlackRock strategists.

How the midterms will affect Trump's economy

A GOP surprise would also be better for growth, and that could be a catalyst for higher rates, according to John Briggs, head of strategy at NatWest Markets.

"If the Republicans hold, stocks are relieved and we'll see a bit of a fixed income market reaction. It could be more muted than the equity market. Even if the Democrats take over, the Fed is still going to go two or three times," said Briggs. A GOP win is "positive for risk, so rates go up a bit. Business confidence keeps growing. You don't have deregulation roll off."

But Briggs does not agree that the GOP would drive the deficit higher. "I don't necessarily see that. If they hold the House majority, it's going to be quite narrow, and the deficit is quite large as it is. If they go through reconciliation, they still have to go through the Senate, but there's just too many roadblocks."

If Democrats pull off a midterm surprise and take both houses of Congress, that would be a negative for stocks and could create a temporary flight to quality in bonds.

But Michael Schumacher, director rate strategy at Wells Fargo, said a sweep either way means higher rates because of more potential for spending. He sees a GOP sweep as more likely and a jump in spending a probable outcome.

"Why would they control spending? They haven't done it so far. More spending seems likely if you get a sweep either way. The U.S. deficit, it's a fact, it's 5 percent of GDP, the biggest in quite some time. It was 10 percent in the peak of the financial crisis, but as far as a non-crisis year, it really stands out," said Schumacher. "If you get the sort of expected outcome which is Democratic House, Republican Senate, I think it's not terribly interesting. Maybe there's a mild rally in bonds, but not much."

Strategists said a Democratic sweep could send buyers initially into bonds, as investors worry about congressional hearings focused on Trump and unwinding of Trump's anti-regulation campaign.

"The tone for business and finance changes and also could be seen as an omen for 2020. Business spending could be impacted. Equities could be down, and yields could fall," said Briggs.

As for the Fed, which begins a two-day meeting Wednesday, the election outcome would not have an immediate impact. The Fed is expected to continue to hike, unless the economy turns down or financial conditions deteriorate.

Three factors will determine if Democrats will take back Congress

Dem win takes heat off Powell?

"What could really matter to the Fed is if something leads to Trump being less inclined to directly criticize Powell," said Ian Lyngen, head of U.S. rate strategy at BMO. Trump has personally criticized Fed Chairman Jerome Powell for the Fed's rate-hiking strategy. "If Democrats sweep Congress, then Trump might be less inclined to take such an emboldened stance against the central bank."

Bank of America Merrill Lynch economists and strategists expect the consensus view of a split Congress, with Democrats taking the House, as the most likely and one that would drive interest rates slightly lower at the long end. A surprise Republican sweep would have the opposite effect. Rates were higher Tuesday, with the 10-year yield at 3.20 percent, and the at 2.92 percent, its highest since 2008.

"Should [a GOP sweep] materialize, we expect that long-end rates might increase upwards of 10-20 bps and the curve would steepen due to higher growth and fiscal stimulus expectations. Regardless of the election outcome, the debt limit is expected to remain a contentious and difficult issue next year," BofAML strategists wrote.

The strategists said under a split Congress, there's an outside chance for additional fiscal stimulus. "Latest
news report suggests President Trump is eyeing a middle income tax cut while the Democrats would look to pass an infrastructure bill in the House if they gain control. It's possible both policies could garner bipartisan support, " they noted.

But Democrats may try to raise taxes on upper-income households or boost corporate taxes, adding that 1 percentage point on the corporate tax rate adds $100 billion in revenue over 10 years.

"We can't rule out the possibility that they ultimately deficit-finance these proposals. Nevertheless, until there is consensus on the source of funding, it is unlikely we see additional fiscal stimulus, affirming our outlook for gradual slowing of growth and gradual tightening by the Fed," they wrote.

But the BofAML strategists also said a Republican hold could mean more tax cuts and another effort to replace the Affordable Care Act as well as other cost-cutting efforts. In this scenario, the GOP should get a timely budget deal and increase the debt limit but House Freedom Caucus members could put up some resistance to a higher debt limit.