With less than twenty days to the US Presidential elections, markets are watching the campaign with baited breath as they await the decision of the American people. Most investors are hoping for a Biden presidency cohabiting with a Republican senate. While Biden will stabilise the broader geopolitical environment, so the reasoning goes, the Republicans will block a promised tax hike from the Democratic candidate should he win the White House in November.
But DBS strategists Duncan Tan and Philip Wee argue that this favourable result is merely a facet of event risks for Asian bond markets. Even before the result is the long and arduous process of confirming the victors in an unprecedented Covid-19 election. Prolonged delays and contested results are expected, creating political instability that could prompt markets to enter a state of uncertainty and risk aversion come November.
“In a mild scenario, we think it is only those bond markets sensitive to foreign capital inflows (Indonesia, Malaysia) that would see some weakness. In a more severe scenario of global deleveraging and rush to cash and USD (just like in March), the entire Asia rates complex could come under pressure,” warn the pair in a broker’s report on 14 October 2020.
See: Rupiah and bonds diverge as global funds shun Indonesia
At the moment, S&P 500 options are increasingly pricing in such a delayed and contested election outcome. With the highest point on the S&P 500 volatility term structure in end-January at the moment, election-related volatility has been priced in to persist into 2021. In contrast, the peak of the term structure hinted that the volatility would recede in mid-December in August and September, hinting at a growing sense of unease within equity markets about political stability.
Asian bonds are likely to see the greatest price fluctuations come November among all other EM regions due to their higher risk exposure. Tan and Wee see the highest event risks being in Chinese, Singaporean, South Korean and Thai bonds due to their stronger economic links with China and greater reliance on trade and exports. This suggests growing worries of renewed US-China trade tensions and fresh tariffs should Trump be elected to a second term.
Tan and Wee also expect to see some de-risking and pricing of event risks into Asian bonds as election day approaches on 3 November. “Using 3-Week and 1-Month ATM FX volatilities as of 9 October, we back out the forward 1-Week volatility for 2-9 November and express it as a ratio over spot 1-week volatility. This captures the expected increase in volatility that would be a direct result of election outcomes,” the pair observe.
On the FX front, the Monetary Authority of Singapore has maintained its exchange rate policy at the status quo in line with DBS’s expectations. With the slope, width and midpoint of the Singapore Dollar Nominal Effective Exchange Rate (S$NEER) - the policy band that MAS uses to control the strength of the SGD - going unchanged, Singapore’s central bank believes that its accommodative monetary stance is likely to remain appropriate for some time to come. Core inflation is seen to rise from 0% to 1% in 2021 compared to -0.5% to 0% in 2020.
“Looking ahead, the MAS reckoned that Singapore’s growth will slow in 4Q from an uncertain and uneven global recovery. According to our model, the S$NEER has kept close to the mid-point of the policy band since the last easing on 30 March to address the pandemic. This has kept USDSGD closely aligned to the peers of its major trade partners,” remark Tan and Wee. They maintain their view that USDSGD trading higher towards 1.38 by end-2020 based on predictions of a firmer greenback for the rest of the year.
On the other hand, the Euro is under pressure, falling below 1.18 against the US Dollar for the first time since 8 October following a plunge in investor confidence to 52.3 on the ZEW survey - its weakest level since May. This stems from a loss in momentum in EU economic recovery as a resurgence in Covid-19 cases saw renewed restrictions, dashing reflation hopes. The European Central Bank is keeping its cards close to its chest, deciding “meeting by meeting” if more stimulus will be called for, with its next meeting to take place on 29 October.
“Apart from another increase in the EUR1.35 trillion ($2.15 trillion) Pandemic Emergency Purchase Programme, the ECB has not ruled out deeper negative rates. The unemployment rate has risen to a two-year high of 8.1% in August while CPI inflation stayed negative for a second straight month in September. Our forecast remains for EURUSD to slide to 1.15 by end-2015,” write Tan and Wee.
There was similar doom and gloom for the Pound, as Sterling is seen to hold a lower 1.25-1.30 range against the US Dollar on the back of weakened economic fundamentals. GDP growth has slowed for a second straight month to 2.1% m-o-m in August from 5.4% in July and 9.1% in June, while unemployment hit 4.5% in August - it’s highest since April 2017. The consumer price index and core inflation are down to 0.2% y-o-y and 0.9% y-o-y respectively in August - well below the Bank of England’s official target of 2%.
If that is not bad enough, the risks of a nationwide lockdown loom large over the UK as the Johnson ministry introduces a three-tier system of local restrictions to address the virus’s resurgence. This marks a significant departure from the British government's initial policy of herd immunity. Odds of a breakthrough in Brexit talks before the 15 October EU summit remain slim as London and Brussels are once more locked in an impasse over the finer points of the UK’s acrimonious withdrawal from the continental bloc.
“The UK could extend a third time the cut-off date for talks from 15 October towards the 1 November deadline by the EU. The BOE has ruled out negative rates for now but short sterling futures have continued to price for one in late 2021,” comment the analysts. A resolution to this stalemate appears to be nowhere in sight.
