Markets are bracing for the outcome of the Jan. 5 U.S. Senate races in Georgia, where a Democratic sweep could boost the likelihood of a massive government stimulus package and an increase in corporate taxes that would send bond yields higher and further weaken the dollar, analysts said.
Republican Sens. Kelly Loeffler and David Perdue are facing Democratic challengers Raphael Warnock and Jon Ossoff, respectively, in a pair of runoff elections for the Senate's last two seats. Analysts said they expect little to no market reaction if Republicans win at least one of the two Georgia races. But if both Warnock and Ossoff prevail Jan. 5, Democrats will narrowly control the Senate and all three branches of the federal government.
"Markets had seemingly bought into the view that Republicans would retain control of the Senate, acting as a constraint on Joe Biden and some of the more radical proposals of the Democratic Party involving tax hikes for corporates and higher-income households and the prospect of greater regulation," said James Knightley, chief international economist with ING. "However, polls suggest the outcome in both seats is very tight, with hundreds of millions of dollars spent on campaigning."
Those polls, most of which have shown both races within a few points, have increased interest in the reflation trade, a bet on a return of inflation spurred by massive stimulus spending under a Biden presidency and Democratic Congress.
"A Democratic Senate will enable Joe Biden to enact comprehensive legislation on the economy, healthcare and the environment as proposed during his presidential campaign," Althea Spinozzi, a fixed-income strategist with Saxo Bank, wrote in a Jan. 4 note. "In short, it implies a bigger stimulus package that will add to the already implemented measures, putting more pressure on inflation."
The 10-year breakeven rate, a measure of market inflation expectations, reached 1.99% on Jan. 31, its highest point since November 2018, according to Federal Reserve data, and a clear signal that inflation expectations are on the rise.
"The reflation story is crucial for bond investors because it implies that the market will not be able to find shelter in [Treasurys] this year as long-term yields rise," Spinozzi wrote.
While the 10-year U.S. Treasury yield has risen from about 0.5% in August to above 0.9% on Jan. 4, it is down from about 3.2% in September 2019.
Ten-year Treasury yields fell in the immediate aftermath of Biden's election victory as markets saw an increasing likelihood of a gridlocked Washington. But yields have risen steadily since then, climbing 15 basis points since Nov. 4, amid market optimism over coronavirus vaccines and as the Democratic candidates in Georgia have continued to look competitive in their races.
If Democrats flip both Senate seats, the 10-year yield could push above 1%, Jim O'Sullivan, chief U.S. macro strategist with TD Securities, wrote in a Jan. 4 note. The yield was 0.93% as of about 8:45 a.m. ET.
Still, with filibuster rules in place in the Senate, narrow control of Congress may ultimately result in little change, Brian Gardner, Stifel's chief Washington policy strategist, wrote in a Jan. 4 note.
"So, no matter what happens in Georgia, the Senate's 60-vote requirement [to break a filibuster] is going to stay in place, gridlock will be firmly in place for 2021, and Congress's ability to pass sweeping legislation will be restrained," Gardner wrote.
If both Democrats win Jan. 5, a large fiscal stimulus would likely bolster risk assets since it would strengthen the global economy, said Lee Hardman, a currency analyst with MUFG Bank.
"It should ensure that the U.S. dollar continues to weaken for now even if U.S. yields move higher," Hardman said.
Hussein Sayed, chief market strategist with FXTM, said the Georgia elections would be "critical" for the U.S. dollar.
"A Democrat win of the two Senate seats could potentially unleash a lot more stimulus which simply suggests more pain for the greenback," Sayed wrote.
The Dollar Index, which measures the U.S. currency against a basket of six peers, was trading at 89.92 on Jan. 4. It has fallen more than 12.5% since March 20 and about 3.9% since Election Day.