The Big Idea

Debatable markets

| June 21, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Presidential debates usually come right before presidential elections, so untangling their separate effects is exceedingly hard. But debates and elections affect uncertainty, and that makes them relevant to markets. A simple history-by-the-numbers shows a noisy tendency for uncertainty to drop and for risk spreads to tighten in the six months leading up to and after debates and elections. Markets seem perfectly comfortable pricing competing visions of policy but just need to know which vision to price.

Pricing political uncertainty

The US has held 22 presidential debates ahead of eight elections since 1992, all debates either in late September or in October ahead of November balloting (Exhibit 1). Except for the 1992 debates, which included independent candidate Ross Perot, all included only the Democrat and Republican nominees. The upcoming debate on June 27 is extraordinary because it is early in the election cycle and neither participant yet has the official nomination of their party.

Exhibit 1: Presidential debates since 1992

Source: Santander US Capital Markets

Because debates typically have come within weeks of balloting, the window for distinguishing the separate market impacts of the two is narrow. It requires data of a frequency and quality that not all markets provide. Instead, reframing the issue as a broader question about the impact of debates and elections makes it easier to analyze.

There is a long list of things that could change and move markets with a new administration or new majorities in the House or Senate. Consider taxes and spending, for example, a wide range of regulations, differences in likely nominees to the Federal Reserve and courts and so on. Differences between candidates or parties on these things can vary from election to election and their prospective ability to get things done can vary, too. Ahead of elections, markets have to give at least some weight to the full range of potential policies and personnel. After elections, the range should narrow.

Because elections narrow the range of possible fiscal and policy outcomes, market volatility should be higher ahead of elections than afterwards. Other events affect market volatility, of course, but the trend over multiple elections should be a decline. And some work does show that options markets price political uncertainty, with higher prices on options that span political events.

Implied interest rate volatility around elections

The picture of expected rate volatility ahead of and after debates and elections since 1992 is noisy but broadly shows volatility does decline. Six months after the debates and elections of 1992, 1996, 2004, 2008 and 2012, the MOVE index of implied interest rate volatility had dropped from its pre-election marks (Exhibit 2A). Six months after the elections of 2000, 2016 and 2020, volatility had gone up. Six months is a long time in markets, and events unrelated to elections can intervene and add noise. Using the median value of the MOVE index each month before and after pre-election debates gives a clearer picture, and median implied volatility declines approaching the election—possibly as the outcome of the race becomes clearer—and continues declining afterwards (Exhibit 2B).

Exhibit 2A: The MOVE index has dropped after five of eight elections since 1992

Exhibit 2B: The trend across elections is for MOVE to decline

Note: The data shows the difference between the MOVE index each month before and after a presidential debate. MOVE shows the implied normal volatility—basis points per year—in a basket of 2-, 5-, 10- and 30-year CMT swaps.
Source: Bloomberg, Santander US Capital Markets

Implied equity volatility around elections

Implied equity volatility does not show as clear a pattern of decline. Six months after the debates and elections of 1992, 2012, 2016 and 2020, implied equity volatility measured by the VIX had declined (Exhibit 3A). But six months after the elections of 1996, 2000, 2004 and 2008, volatility had gone up. Using the median value of the VIX, the trend before and after an election still is unclear (Exhibit 3B). The equity markets offer no support for the idea that volatility drops after elections.

Exhibit 3A: The VIX has declined after four of eight elections since 1992

Exhibit 3B: The trend across elections for the VIX is unclear

Note: The data shows the difference between the VIX index each month before and after a presidential debate.
Source: Bloomberg, Santander US Capital Markets

Debt spreads around elections

Debt spreads also add at least a little to the case for lower uncertainty after elections. A range of work shows credit and other risk spreads vary with uncertainty. Six months after the elections of 1992, 2000, 2012, 2016 and 2020, spreads on investment grade corporate debt had generally tightened (Exhibit 4A). Six months after the elections of 1996, 2004 and 2008, spreads had widened. Again using median values of investment grade spreads, spreads tend to tighten into elections and continue tightening afterwards (Exhibit 4B).

Exhibit 4A: Investment grade OAS has dropped after five of eight elections

Exhibit 4B: The trend across elections if for investment grade spreads to tighten

Note: The data shows the difference between the Bloomberg investment grade corporate index OAS each month before and after a presidential debate.
Source: Bloomberg, Santander US Capital Markets

Tilting towards lower volatility and tighter spreads

The presidential debate scheduled in a few days should give the market its first side-by-side chance to gauge the potential impact of the candidates. A second debate scheduled for September 10 follows and then the election on November 5. History leans in the direction of declining rate volatility and tighter spreads on debt, but only within the bounds allowed by eight elections since 1992 and very noisy data. Increasing clarity on the Fed path and the approach of long-awaited Fed cuts also argue for lower volatility and tighter spreads as the year progresses. Absent a compelling reason otherwise, that’s the direction investors should tilt their portfolio.

* * *

The view in rates

Fed funds futures now price in 48 bp of easing this year as of the Friday close, almost unchanged from a week ago. The market sees a 63% chance of a cut in September and a 78% chance of December. The Fed keeps saying it will need to see several months of benign inflation readings and the May report has started the clock. If June and July also show benign month-over-month inflation, that could set up the Fed for a September cut. The PCE core deflator arrives on June 28 with employment on July 5 and CPI on July 11.

Other key market levels:

  • Fed RRP balances closed Friday at $421 billion. RRP balances have bounced between $400 billion and $500 billion since the start of March. That range has held despite yields on most Treasury bills running well above the RRP’s 5.30% rate.
  • Setting on 3-month term SOFR closed Friday at 534 bp, unchanged in the last week.
  • Further out the curve, the 2-year note closed Friday near 4.73%, up 3 bp in the last week. The 10-year note closed at 4.25%, also up 3 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -47, steeper by 1 bp in the last week. The 5s30s closed Friday at 13 bp, steeper by 3 bp over the same period
  • Breakeven 10-year inflation traded Friday at 223 bp, up 5 bp in the last week. The 10-year real rate finished the week at 202 bp, down 2 bp in the last week.

The view in spreads

Implied rate volatility has bounced higher lately, putting temporary pressure on risk asset spreads. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 94 bp, wider by 4 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 143 bp, 1 bp tighter on the week. Par 30-year MBS TOAS closed Friday at 32 bp, tighter by 2 bp in the last week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies, that that has as much to do with the price of used cars as it does the consumer balance sheet. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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