Midterms may deliver a short-term correction in US equities

As a trader, there are a couple of major events over the next few weeks I am watching. First is the US midterm elections. By now, we have a fair idea of which side the Congress will be leaning.

Early polls leading up to the midterms showed a mixed picture with a larger Democrat majority forming in the House of Representatives, as the Republicans (GOP) were poised to retain the Senate. While history has shown us that early survey projections are not to be completely trusted, if we assess the impact on markets assuming this projected split between the houses, I expect to see a correction in the short-term prices of US assets, with equities primarily susceptible to uncertainty risk.

While there tends to be little historical correlations between midterms and the performance of US assets, there is a lot more riding on the line. A lower house dominated by Democrats would see more barriers to a bevy of Mr Trump's proposals from immigration law to his foreign and fiscal policies, not to mention the heightened efforts behind stronger investigations against the president. Such conditions would create political gridlock in Washington and the attached market uncertainty will keep US asset prices sensitive throughout the ensuing months.

Markets have lapped up Mr Trump’s economic vision – US equity indices are coming off historical highs – and in the event that the GOP can retain the House along with the Senate, this would bode well for US bulls.

While equities could be in for a bout of volatility, expect to see further consolidation in the US Dollar Index above 95 levels with a gradual push higher through the end of 2018. I noted resistance between 96.40 and 97 levels last month and as expected buying support faded in that channel. I see the index primed for a move above 100 through the next six months as a result of the continued emergence of interest differentials from a hawkish Federal Reserve.

The formula remains simple, as the US data docket continues to show steady signs of expansion, a resulting hawkish Fed will keep rate hikes on the table. The US central bank remains at the forefront of its rate raising cycle, with at least one more rate hike priced in for this year, followed by three projected for 2019. To put that in perspective, US interest rates would be 3 per cent higher than their European counterparts by the time the European Central Bank looks at rates next summer.

The second major event is the Fed’s November rate meeting, which kicks off today. While I do not foresee any changes to US rates I am watching for clues on how optimistic the rhetoric is when the Fed statement is released at the conclusion of the two-day meet.

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Famously during the last meeting in September, the Federal Open Market Committee dropped “accommodative” parlance from their statement and while we do not have any economic projections releasing from the November meet, I do not foresee any significant upgrades in their hawkish tones and instead of a reaffirmation that price pressures remain under control.

Last month’s Personal Consumption Expenditure deflator, more commonly known as the PCE price index, came in at 1.6 per cent, weaker than the 2.2 per cent print analysts expected. While this print is under control, I would finally note the optimism in the Fed around the current state of the US economy, especially following that solid third-quarter gross domestic product print last month – coming in at 3.5 per cent - well above the expected 3.3 per cent.

I am also keeping a close eye on next week’s US core prices index reading due out on November 14. Expectations are for core year-on-year prices to come in at 2.2 per cent. While the earlier mentioned PCE price index is a more broad-based measure of the price pressures of the goods and services US businesses and manufacturers are selling, next week’s CPI print is a measure of what US consumers are buying. Both are crucially important inflation barometers for the Fed and any downside variance in next week’s print would result in dollar weakness and vice versa.

Across the pond, the euro and British pound Dubai Gold & Commodities Exchange (DGCX) contracts continued to experience choppy trading conditions through to the end of October. The British Pound to US dollar contract sunk to 1.27 levels – easily filling my targets. News before the weekend of a potential deal being struck with the EU has sparked a fresh pound-buying spree to take GBP/USD above 1.30 levels – however, my predicted October resistance level at 1.31 still remains intact. Amidst a packed UK data docket, UK GDP due out this Friday is expected to grow to 1.5 per cent year-on-year, while UK inflation next week is expected to expand to 2.6 per cent;  keep an eye out for further developments surrounding rumours of a Brexit deal getting finalised as early as this month.

While the GDP and inflation prints will drive intraday volatility in the pound, the deliverance of a deal would open the door to a move through 1.33 by the end of November. On the flip side, any resulting delays from domestic political hurdles to Prime Minister Theresa May would expose 1.27 levels once again.

And finally, DGCX’s euro/USD contract bounced off my target at 1.13 given two weeks ago; and I expect another test of this level through the weeks ahead.

Gaurav Kashyap is a market strategist at Equiti Global Markets. The views and opinions expressed in this article are those of the author and do not reflect the views of Equiti