Investors have become increasingly attuned to the risks posed to the US economy should policymakers hesitate on another round of stimulus © Mark Lennihan/AP

As the US presidential election fast approaches, investors are betting on a so-called reflation trade that is expected to lift stocks and take the shine off Treasuries and the dollar.

The wager rests on the assumption that the upcoming matchup between Donald Trump and Joe Biden will result in a big enough victory for Democrats that the party will be able to usher in a substantial fiscal stimulus that will eventually help to fuel higher US growth and inflation.

BlackRock publicly hopped on the bandwagon this week, announcing that it was downgrading US government debt and upgrading its inflation-protected counterparts.

“Markets are increasingly reflecting a unified Democratic government outcome that may lead to a significant fiscal expansion,” the world’s largest asset manager said. “This electoral outcome would bring forward the market pricing of the higher inflation regime that we were already reflecting in our strategic asset views.”

Still, the path to a more robust recovery is by no means a clear one — even if Democrats do win on November 3, as polls currently indicate. Rather, much depends on the distribution of power in the Senate, and if Democrats can win a large enough majority to push through a major Covid-19 relief bill.

“The likelihood of a stimulus package being signed into law in early 2021, as well as the potential size of that package, probably goes down as the size of the potential Democratic Senate majority shrinks,” noted Michael Schumacher, a senior macro strategist at Wells Fargo. “Not all blue waves are created equal.”

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Investors have become increasingly attuned to the risks posed to the US economy should policymakers hesitate on another round of stimulus. After moving aggressively at the peak of the financial turmoil in March and April to support hard-hit Americans, congressional leaders have since been locked in a stand-off over the contours of a new aid programme. 

The true “nightmare” scenario, according to Steven Blitz, chief US economist at TS Lombard, is another divided government in which Republicans either retain the Senate in the event of a Biden presidency, or the status quo persists, coupled with headline economic data that looks solid enough but masks underlying pain.

“If you have a Senate that is not going to give Biden the fiscal freedom that he needs, they are going to make this downturn worse,” he said.

However, a razor-thin Democratic Senate majority presents its own problems. Republicans currently hold a 53-47 majority. This election, 23 Republican seats and 12 held by Democrats are up for grabs. So Democrats must pick up at least four more seats to gain control of the upper chamber. They can afford to secure a net gain of just three seats in the event that Mr Biden also wins the White House, as the vice-president is set the task of breaking a Senate tie.

According to modelling of poll data by FiveThirtyEight, Iowa, North Carolina, Maine, Arizona and Colorado are red states currently leaning blue in senate races. Meanwhile, Republican Tommy Tuberville appears likely to defeat Democratic incumbent Doug Jones in Alabama.

“If Democrats win control of the House, Senate, and White House, the size of the Senate majority might be just as relevant as who controls it,” wrote a team of analysts led by Jan Hatzius at Goldman Sachs in a recent note. 

Line chart showing how Trump and Biden are doing in the US national polls

Libby Cantrill, head of US public policy at Pimco, adds that newly elected Democratic senators from swing or red-leaning states will also have a “moderating effect” on policies.

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As such, investors believe a narrow Democratic majority of 50 or 51 seats is likely to lead to less fiscal support than a majority of 53 or 54 seats. A 60-seat supermajority appears far out of reach. That means major legislation will need some buy-in from Republicans unless Democrats manage to abolish the filibuster, which requires the support of 60 senators to end a debate and move to a vote. That would permit bills to be passed with just 51 votes.

They can also try to push through a stimulus package via a special legislative process called “budget reconciliation”, which allows for certain spending measures to be passed with a simple majority.

The surge in coronavirus cases in the US and around the world has only upped the urgency.

“Saving money now will cost us much more money in the future,” said Ron Temple, head of US equities at Lazard Asset Management. “If we wait until it’s obvious that small businesses have failed, it’s too late.”

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