How Will the US Presidential Election Impact Foreign Exchange Trading?

Tom Cleveland

If you are a U.S. citizen and registered to vote, are you planning to vote for Hillary Clinton or Donald Trump? If you are a forex trader, what can you expect before, during, and after the vote takes place, as far as trading opportunities in the currency markets? The answer to the latter question begs an answer to the former, but my objective today is not to express any preference for whoever might get elected. My goal today is to prepare you for the inevitable consequences that will transpire over and past the next thirty days or so. For the benefit of all, lets put aside our political leanings for a bit.

Elections and referendums, for that matter, fall under the classification of fundamental forces that can drive change in our financial markets. They will always contain a degree of what is called “event risk”, regardless of the situation, but the Presidential Election campaign in the United States this year has already been one of the most contentious in memory. The last debate drew questions from a gathering of undecided voters, but it was difficult to imagine that even a handful of voters could have remained that way up to this point. Whatever happens in November, roughly half of the electorate will be pleased, while the other half will be equally displeased. It will not be easy sledding thereafter.

We have already witnessed an over-the-top referendum in the UK, when the Brexit “Leave-or-Stay” votes were cast this past June. Emotions ran extremely high, before and directly after. Financial markets may have settled down, but the ramifications are still muddling along, and Pound Sterling has yet to recover any lost ground. There have been several analogies drawn in the press and in public interviews that suggest that we might observe a very similar repeat of events before and after votes are cast in early November.

The bouts between factions that desire change sound the same. No one seems satisfied with the status quo. The need to find an enemy to blame is paramount. Both Democrats and Republicans exhibit a level of disgust with the intransigence of the current political process. How to fix what is broken is open to widespread speculation, sometimes driven by the facts and sometimes not. If change is the true objective, then all that is actually being debated is how quickly and what form the change will take. Will it be open chaos or a deliberate rejection of the old for something new? As with Brexit, uncertainty is running high, and uncertainty is not a condition that financial markets embrace easily.

From a trading perspective, we may have a political leaning, but, what is more important, however, is how will this drama play out over the last quarter and even into next year. How will stocks, bonds, and currency pairs react? Are there foreseeable patterns that could guide our trading strategies in the weeks to come? We also know that these events will not occur within a vacuum. The oncoming build up to the Fed’s meeting in December will heighten uncertainty, and then we also have the rest of the world to think about. China, Europe, developing countries, and even terrorists will not sit on their hands, waiting for Americans to make up their minds. Fundamental forces will abound.

What patterns should guide our thinking before the election takes place?

We have written recently about what has been called “Presidential Election Cycle Theory” and about what investors should know about U.S. Presidential Election market impacts. “The prevailing press narrative about the upcoming U.S. Presidential Election is that it will be disruptive, both before, during, and after the process has concluded. Uncertainty will reign, as will the volatility that it generates.” Uncertainty will typically be accompanied by volatility, a good thing from a trader’s perspective.

In summary, a macro-analysis of S&P 500 data for the past fifty years indicates that returns during an election year are roughly equivalent to general market averages, even more so if you ignore 2008, which was overly influenced by the financial havoc rendered by the Great Recession. If one digs deeper and only looks at elections where no incumbent is in the race, then the conclusions turn a bit murkier. Instead of neutrality, market results fall nearly 10% from the general average. The explanation has been that a build up of hopeful anticipation that things will get better raises market values, until the reality of having a new president takes hold. A “sell-on-the-news” response is the result.

What can we expect before the November 8th Election Day?

October is a month known for volatility spikes for whatever reasons. Analysts that follow the VIX Index swear by this repeating pattern, and a U.S. Presidential Election can only exacerbate previously observed trends. The general consensus the world over is that elections of our top leaders equate to changes in public and foreign policies. In this election, the degree of change has yet to be determined, but the assessment by the press is that a Clinton win will be “gentler” than a Trump victory. Trump has proposed an agenda of massive change to political infrastructure, trade agreements, and foreign affairs. His Democratic opponent has proposed a path that builds upon the status quo.

Financial markets are in a quandary. They typically respond well to Republican candidates, since the belief is held that their policies will favor businesses with lower taxes, better trade arrangements, and lower government spending. Surveys have shown that nearly all electorates are conservative by nature and reluctant to embrace change. The quandary in this year’s race, however, is that the Republican candidate, Donald Trump, has based his campaign on being an outsider that will totally revolutionize the existing system, and “Make America great again”. Democrats claim the system needs minor changes, is already great, and has recovered from the worst economic recession since the Great Depression, all brought to us by the last Republican regime in office.

If you want a homework assignment, you can go back in time and check the reactions of the Mexican Peso and the Aussie Dollar to previous political events. Recent polls suggest that Clinton won the first debate, and, as a result, the Peso and the Aussie Dollar both rebounded versus the USD. Trump has threatened to bill Mexico for a wall against immigration and to attack all deals with China. Both policy changes would impact existing trade arrangements negatively in the short term, the reason both currency pairs have been in flux of late. These trends may continue up until Election Day, but history shows us that markets tend to enter a “calm” phase before final results are broadcast.

What are expectations after Election Day for near-term impacts?

The simple truth – Expect volatility to rule. There will always be “weak hands” that will jump to change positions, as soon as a little clarity arrives. Cover trades will reposition themselves, looking for any safe haven to wait out the storm. In the past the USD has benefited from these capital flows, but the current expectation is that the Japanese Yen and the Swiss Franc will be the greater beneficiaries, no matter who is elected.

A Clinton victory, since the market perceives a more gradual approach to change by her supporters, will lead to more stability for both equities and the greenback, at least until the dust settles and the focus shifts back to the Fed’s December meeting. A Trump win, on the other hand, will punish the Peso and the AUD, but only to the extent that this damage has not already been built into the then prevailing valuations. Review previous ranging behavior for these pairings, compared to events on the campaign trail, to determine where support levels have gravitated in the past for guidance.

You may not need to focus only on the Mexican Peso or Aussie Dollar. Volatility will bring chaos to all markets until a quasi equilibrium is re-established. The USD may dip, but then return to a higher level, as the Fed meeting draws near. Those investors that decide to change direction will roil the markets to a fair degree, enough to make swings in all major currency pairs a daily phenomenon. Look for trends, but do take advantage of riding the strength curves, and then fading them. Trading rollarcoasters in the forex market can be fun and profitable, as long as the ride follows a predictable path.

What are the longer-term impacts for financial markets following the election?

Whether we like it or not, politics do impact our financial markets and cause the U.S. Dollar to fluctuate, but markets often react to perceptions, rather than waiting for reality to take hold. Heightened political risk can cause capital to flow out of U.S. investments from foreign sources, thereby beating the Dollar down in value. History has also shown us that the year following a Presidential Election is often beset with recession, another insight derived from Presidential Election Cycle Theory.

Is a recession a certainty in 2017? Not necessarily, but markets tend to react to the hype in an election year, only to have the air come out of the balloon the following year, when beneficial policy changes run into political roadblocks. The potential for a business slowdown exists without regard to which party ultimately controls the White House. The global economic “Gordian Knot” constructed by our central banking community must unwind at some point, and, although these bankers are committed to a gradual unwinding, even the slightest of political turmoil could wreak havoc upon our markets.

Concluding Remarks

We have less than four weeks until the U.S. Presidential Election is decided. Financial markets will receive a jolt, no matter which candidate wins. Volatility will reign, perhaps, more so if there is a Republican victory. Election Day is not a holiday. Markets will be open. Forex pairs will be traded with reckless abandon. Opportunities for gain will abound in the short term, but longer-termed issues will have to wait until 2017 to be sorted out.

The advice at this stage is to be prepared for any result. Stay cautious. The Brexit referendum has already served as a precursor, and millions were made trading the fluctuations that resulted from that vote. It is a given that huge bets will be placed on both sides of this November’s election equation and that half of these positions will have to be unwound, if not already hedged. The capital flows from these changes will roil financial markets, at least for a few days, so be prepared with well thought out trading strategies for every possible situation.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Tom Cleveland
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