Wall Street is already betting on the rematch between Biden and Trump

Nine months before the presidential election, investors are already thinking about how financial markets might react to the outcome of the election, and how they should act to prepare for it.

Stock markets have soared to record highs in recent weeks, while government bond yields, which support consumer and corporate interest rates, have fallen from a recent peak in October. Despite the uncertainty of making political predictions, money managers are already thinking about how the election could change the mood in the markets.

Red wave, blue wave or divided government?

The combination that investors see as the most likely to cause a shift in financial markets in November – and therefore the scenario traders are spending the most time on – is a so-called red wave, with former President Donald J. Trump returning to the White House along with a Republican sweep of Congress.

When Trump won the 2016 presidential election and Republicans retained control of the House of Representatives and the Senate, expectations of lower taxes and a looser regulatory environment depressed growth expectations and led to major stock indexes rising. These policies, which reduced government revenues and increased financing needs, also caused a sharp increase in government bond yields.

In the event of a red wave, investors expect something similar. “I think you'll see something directionally that rhymes with it,” said Erik Weisman, chief economist and portfolio manager at MFS Investment Management.

A blue wave – a Democratic wave of Congress and President Biden's re-election – is seen as less likely and therefore receives less attention, although that outcome could also lead to increases in government spending and higher borrowing costs.

And should the election result in a divided government, as is currently the case, the prospect of further legislative deadlock would likely dampen any market reaction.

“What matters is a red wave or not,” said Mike Gladchun, associate portfolio manager at fund manager Loomis Sayles.

Trading the interest rate difference

One of the most talked about trading ideas this election reflects a strategy that is already popular and tied to expectations that the Federal Reserve will soon begin cutting interest rates.

“If there was ever a time to bet early, this would be it,” said Mr. Gladchun, who added that while he is not yet making any trades related to the election, he is already in investment talks about it.

Over the past six months, investors have been betting on a widening gap between short-term interest rates, which are closely tied to Fed policy, and longer-term interest rates, which are also influenced by growth, inflation and the amount the government needs . to borrow.

If inflation continues to cool and the Fed starts cutting rates, as many expect this year, market yields are normally expected to fall in the short term. In the meantime, the strength of the economy and concerns about government bonds are expected to keep interest rates high in the longer term.

A red wave would be another reason to bet on a widening gap between short- and long-term interest rates, investors say.

“It would be too early to initiate this transaction if this were the only reason, but there are many reasons why it already makes sense without thinking about the elections,” said Calvin Tse, head of research at BNP Paribas. “The election is a potential positive tailwind for trade.”

Still, there are risks associated with devising deals so far in advance of the election, not least that Mr Trump is still fighting a legal battle on multiple fronts, including over his eligibility to even appear on the November ballot .

Preparing for volatility in stocks

Stock markets could be harder to predict than bonds, with investors saying they currently prefer trades that would benefit from higher volatility rather than betting on a specific price direction.

While lower taxes and deregulation would likely be welcomed by corporate America, higher bond yields – and therefore higher borrowing costs – would not. It is also difficult to predict how the Fed will respond to stimulative fiscal policy if the economy continues to hum along. (Mr. Trump said recently that if elected, he would not reappoint Jerome H. Powell to another term as Fed chairman.)

That could also lead to volatility in the bond market.

The stronger dollar trade

Another idea being discussed among investors is betting on a stronger dollar. Mr. Trump has said he would impose new tariffs on imports, which increase the value of the dollar by making it less attractive to spend on foreign goods.

At the same time, some investors worry about the impact that Trump's authoritarian sympathies could have on the perceived strength of the U.S. legal system, which underpins the country's status as a global financial center.

“To the extent that Trump is seen as not being good for the rule of law, that's not good for the dollar,” said Mr. Weisman of MFS Investment Management. “Do you want to own American assets in a world where the rule of law may not mean as much as it used to?”