An Eventful Week for Fixed Income Investors

Although the long-term economic makeup of the U.S. economy is unlikely to change significantly based on the results, in the short-term, market volatility has the potential to bring opportunity in a variety of asset classes.

Clearly, the presidential race will be the most widely discussed outcome, but for investors, whether Republicans retain control of the Senate will likely have the larger near-term impact on markets. Should the Senate flip Democratic, the prospects for various policy actions, ranging from additional fiscal stimulus to healthcare policy to infrastructure spending, will change meaningfully. This could drive asset prices as investors quickly price in a “blue wave” government that pushes through legislation more swiftly than in the current environment.

For the rates markets, a democratic sweep could further the move higher in long-term interest rates that we’ve seen over the past several weeks. The Federal Reserve’s policy actions tend to have the largest impact on the front-end of the yield curve, while longer-term rates, such as 10- and 30-year bonds, are dictated by investors and influenced by factors such as economic growth and inflation. As we’ll likely hear from the Fed this week at the conclusion of their two-day policy meeting, the FOMC expects to keep the Fed Funds Rate at the zero bound for the foreseeable future, thus keeping short-term rates low. This makes the risk to the rates market come in the form of a yield curve steepener, as a blue wave would increase the possibility of a meaningful fiscal stimulus package being passed. This would improve the prospects for economic growth and increase the supply of long-term bonds being sold by the Treasury.

For municipals, we think a blue wave would be positive for the market, as a portion of the aforementioned stimulus package would likely be targeting towards economic support for state and local governments. In addition, any increase in tax rates for individuals and corporations would increase the value of the tax-exempt interest income that most munis produce.

For corporates, we believe any increase in the corporate tax-rate can be absorbed without meaningfully impacting credit quality. Corporations have taken advantage of the market environment over the past several months to issue significant quantities of long-term debt and retire near-term liabilities. A large fiscal package would also help the economy, and by extension, increase demand in many sectors of the corporate market.

Overall, this stands to be a historic week, and one that will not soon be forgotten. For bond investors, the ability and willingness to be nimble and opportunistic should asset prices move away from long-term fundamental value could allow for value-added trades. We are also cognizant that the election is only one piece of the puzzle. The trends related to the Covid-19 pandemic are also moving asset prices, and until there is clarity related to the medical situation both globally and in the U.S., we expect this to be a continued driver of short-term volatility.

Related: Banks: The Fed Has Bondholder’s Back