How the US election will affect the risk-on/risk-off trade?

THE US PRESIDENTIAL election will take place on November 6 2012 and will as always, play an important factor in the financial markets. The upcoming election will set the tone to demonstrate if risk-off trading, synonymous with the 2008 crash recognising peo-ple selling investment into cash to reduce loss, has been changed to risk-on trading where people capitalise to develop a likely return from investments. Given the current economic climate, this could have a large effect on this risk-on/risk-off theme that has been driving sentiment – something that will affect the dollar and ultimately all businesses involved in international trade through the exchange rates.

The election brings with it the potential for change in how the US economy is run. If we cross-examine the financial agenda of the two candidates – it is obvious why markets will be cautious going into the result as they are polar opposites. Obama advocates a tax and spend agenda, arguing that austerity would harm a recovery. Conversely, Romney wants to cut the deficit and vows to cut spending to 20% of GDP from 24%.

Romney is not an advocate of quantitative easing. Should Romney become President, one outcome could be the removal of Federal Chairman Ben Bernanke. Given this, it will be no surprise to see the US Dollar strengthen before the election as the prospect of change and uncertainty will play on the mind of investors. Of course, if Bernanke were to be removed, the policy of on-going QE would come under close scrutiny, as it could be argued the unofficial policy of the Federal Reserve since 2009 has been to weaken the US Dollar via QE.

Meanwhile, outside the US there are global ramifications which could further aid the “flight to safety” which is causing a stronger US Dollar. For those nations (such as China- a big market for the UK) that have their currency pegged to the US Dollar, the election is important because in effect they are importing US monetary policy.

China is also a big issue for the US elections, and particularly what is perceived as its currency being undervalued (causing harm to US producers). Given the timing of recent comments from Beijing that signalled little likelihood of further Yuan appreciation in the near future, there are concerns whether there will be further political gamesmanship ahead of the US elections that will further strengthen the US’s currency.

At the time of writing (October 23rd), the Gallup tracking poll reported Romney had extended his lead to 6 points. Markets hate uncertainty and as we approach November 6th it seems likely that risk aversion may once again come into play. This is only one of several opinion polls, but 6 weeks previously it appeared that Obama seemed likely to maintain a lead, but now it appears to be more of a coin toss.

Historical research suggests that when we have seen high returns in the stock markets it is unlikely that the leadership will change in a US Presidential Election. In contrast, when the stock market had been doing badly, change is normally anticipated. If the theory holds true then it suggests Obama will be re-elected given he has presided over a strong bull market in stocks for the last three years.

Whatever happens, it is likely that we will see the US Dollar strengthen as uncertainty will continue to circulate the market prior to the polls closing. It is plausible that US Dollar strength will continue whoever wins according to the well-known cyclical study, the Yale Hirsch Presidential Election Cycle Theory.

This report suggests that after all the pre-election hype it is common for the President to introduce his least popular policies so as to get them ‘out of the way’ in the hope they will be forgotten by the time the next election comes round. Given the inverse relationship with the US Dollar, this suggests a rise in the Dollar as the most probable outcome following the election.

Financial directors which are keen to avoid the fluctuations that are accustomed with the risk on/risk off trade should speak to their currency dealer or a currency specialist about the best instruments available to them to suit their risk needs.US politics and foreign policy implication are going to influence import/export prices, causing uncertainty in the FX markets after the elections. It will take time for the markets to settle once the unpopular policies have been implemented. This is likely to continue into the Christmas period, where volatility will be around the corner due to lower liquidity, holding the rocky road for the currency markets into the New Year.

Jamie Jemmeson is a trader and foreign exchange expert at Global Reach Partners