The Democrats are on the verge of winning the two Georgia Senate elections, according to news agencies as multiple sources have called the race for Raphael Warnock while Decision Desk HQ has called the race for Ossoff.
With these victories, Democrats would gain full control of Congress and the White House, which Goldman writes would "lead to greater fiscal stimulus in the near-term. Later in 2021, we would expect incremental increases in taxes to finance similar amounts of new spending, though both would be a fraction of what the Biden campaign proposed." This means that, at least for the next two years, the US is set to descend into that circle of monetary hell reserved for nations which openly engage in helicopter money (everyone knows what happens after).
In addition, BofA adds that Dems will have control over the Presidential appointment confirmations– including appointments to regulatory positions, cabinet and judicial positions. But perhaps most importantly for markets, the Dem sweep clears the way for the use of reconciliation to set spending and tax levels without threat of filibuster.
First, a few key points on what a Blue Wave would mean for domestic politics, courtesy of Goldman:
- Assuming they win both seats, this would put Democrats at 50 seats in the Senate and in the majority with Vice President-elect Kamala Harris’ tie-breaking vote.This gives Democrats control of both chambers of Congress, albeit with very slim margins in both (Democrats hold 222 seats in the House, 5 seats into the majority).
- A Democratic Senate majority to allow for greater fiscal policy changes. This would include additional fiscal stimulus in the near term — Goldman has penciled in $600bn (2.7% of GDP) in additional stimulus under this scenario — followed by a limited amount of tax increases and spending increases later in the year.
- Outside of fiscal policy, other legislation would likely need 60 votes to pass in the Senate. Notably, more than one Senate Democrat has already publicly opposed eliminating the filibuster. This means that bipartisan support would still be necessary to pass legislation on issues like infrastructure, a minimum wage increase, tech regulation,and environmental policies.
- That said, Democratic control of the Senate could still make a difference in some of those areas, as Democratic leaders would control the agenda in that chamber, and President-elect Biden would have greater flexibility to nominate officials whom
Bank of America economists generally agree with this assessment, noting that the Dems will likely use these powers to pursue several policy goals – including infrastructure expansion including green initiatives, as well as social goals such as access to healthcare and increased social and economic equality. Coming in more aggressive than Goldman, BofA thinks the Dems would inject $2-4tn in deficit spending with much of it frontloaded within the 10-yr budget window via reconciliation. This would provide upside risks to the bank's second half 2021 outlook on GDP growth and inflation.
How about implications for markets? Here are some key observations from BofA economist Joseph Song:
Higher and steeper rates, funding needs absorbed by Tbills
A Dem sweep would "increase the conviction level" in BofA's 2021YE 10y rate forecasts of 1.5%, 5y-30y curve at 190bp, and 10y inflation B/E around 2.25%. In addition, 30y swap spreads could tighten potentially down to the -30bp area which would be a buying opportunity. Better inflation could pull forward Fed plans to normalize policy which could continue to lift long-dated rates. Also, the scope for WAM extension in the Fed’s QE program likely diminishes, helping the curve steepening dynamic, in our view.
BofA also believes that the Treasury is currently "well positioned to finance increased deficits over the next few years" so the actual supply impact could be small and would most likely be seen first in T-bills. This is because
- nominal bond coupon size increases and expected increases in TIPS early next year have already raised annual gross coupon supply by about $2tn versus 2019 levels, and
- the Treasury has $1.5tn in cash at the Federal Reserve that could provide $700bn in funding if the Treasury reduces it back to its targeted $800bn level.
The cash balance could potentially fall further, which would provide additional funding. A blue sweep reduces the outlook for coupon size cuts in 2021.
USD weakness to accelerate, for now
Global risk assets should react positively to prospects for materially-higher fiscal stimulus alongside less political brinksmanship. This suggests that the first order effect of a Democratic blue wave will be an acceleration in the pace of USD depreciation to begin 2021. Accordingly, BofA expects a sharply weaker USD on the order of 2% over the next couple of weeks, bringing EUR/USD to its 1.25 year-end forecast "quite quickly."
However, in the medium run, the case for sustained USD weakness becomes much less clear and a rally more likely due to fiscally-driven better growth and potential worries over tax and regulatory shifts. BofA expects a fiscally-driven higher US relative growth profile to provide fundamental support to the US dollar, particularly as the US curve steepens and US rates rise relative to the rest of the world (emphasis: the Euro Area). Indeed, growth divergence could be along the lines of what we saw with the Tax Cut and Jobs Act of 2017, which precipitated a re-pricing of the Fed and attracted capital flows into US assets. While BofA also expects that the Fed will remain as easy as possible for as long as possible, at some point the market will expect that countercyclical monetary policy orthodoxy will kick in and the Fed will have to move provided that conditions for exit from the zero lower bound have been achieved. Moreover, potential worries over tax and regulatory shifts under a blue wave could undermine risk appetite, leading to a bid for the dollar as the reality of higher taxes in the out years assuages concerns about US deficits and an orthodox Fed undercuts the case for USD debasement. "At that point, short USD positioning would be at considerable risk of unraveling."
Finally, while pricing out of USD risk premium to date is justified by progress toward global recovery, BofA is not convinced that a blue wave will be enough to drive the dollar to sustainably undershoot absent extreme risk euphoria or a surge higher in global growth disproportionately benefiting areas outside of the US. For this reason, any USD weakness will ultimately prove temporary.
A few wrinkles to the reconciliation bill
There are a few constraints on reconciliation bills worth noting.
- First, the reconciliation bill cannot add to the deficit beyond a 10-year window.
- Second, only spending, taxes and the debt limit can be addressed by reconciliation. Provisions that do not directly impact the budget (i.e. new regulations such as increases in the minimum wage) cannot be included.
- Third, typically only mandatory spending provisions are addressed through reconciliation, rather than discretionary spending which is controlled through the annual appropriation process.
- Last, Congress can essentially use the reconciliation directive to adjust spending, revenues and the debt limit only once per fiscal year.
These constraints may somewhat hamper what Democrats can pass through reconciliation. One area of focus for the Dems will be to advance the climate change agenda but there will be obstacles. For example, they cannot outright add new regulation on clean energy. Moreover, many moderate Democrats from swing states (e.g. Manchin, Sinema, Kelly) are likely to oppose more progressive policies. However, they can add new tax provisions (e.g. tax credits) to incentivize climate friendly infrastructure or expand on mandatory spending in other departments (e.g. education, energy) to inject federal funding to new public works projects.
That said, Democrats will likely have the opportunity to pass 2 reconciliation bills this year. A reconciliation bill requires that Congress first pass a budget resolution containing a reconciliation directive, which is not a law, but rather a product of House and Senate budget committees. Congress did not pass budget resolution for FY2021, so the Democrats could pass two budget resolutions (one for FY2021 and one for FY2022), giving them an additional opportunity to implement their policy agenda.