The size of a fiscal stimulus package will be crucial.
The increased probability of a Democrat-controlled Senate had contributed to a rise in the 10-year Treasury yield to 0.70% by October 15, because a large fiscal stimulus is more likely if the November elections do indeed produce a Democratic ‘blue wave’.
We see a 30% probability of a Democratic ‘blue wave’, with the Democrats controlling both houses of Congress. This could mean a substantial fiscal package that includes large infrastructure and green investments. This scenario could cause the 10-year yield to rise above 1%, while an increase in the Fed’s quantitative easing and/or a potential shift towards purchases of longer-dated bonds would likely contain this rise.
However, our central scenario (40% probability) foresees a divided Congress, where the Democrats do not gain control of the Senate, but Biden becomes president. In such a case, the 10-year Treasury yield could remain within a 0.6%-0.9% range, depending on the size of a post-election fiscal stimulus. By contrast, Donald Trump’s re-election and a split Congress (25% probability) could potentially mean a lower 10-year yield because it would place a question mark over a large fiscal stimulus and might lead to a further escalation of US-China tensions.
US investment-grade (IG) spreads barely moved during the equity market sell-off of September, while the widening of high-yield (HY) spreads was limited. For IG investors, the increasing share of long-dated corporate bonds being issued are a greater risk, as the sharp tightening of spreads since late March hs encouraged companies to issue longer-dated bonds. Although we expect only a limited rise in the 10-year US Treasury yield, it could be enough to detract from IG’s performance. Should the Democrats make a clear sweep in the elections, we would expect a risk-on rally that is likely to tighten credit spreads more than we foresee in our central scenario. In this case, a thicker spread cushion and a much lower effective duration could mean that US HY could outperform IG, and this despite the former’s large exposure to the shale oil industry and a default rate that stabilised at 7.2% in September.