Yields and the dollar are falling because investors expect the Democrats’ win to slow the AI boom and limit Fed rate hikes, although a strong US economy keeps the setback contained, writes Gary Howes, Editorial Consultant, FX Hub.
Yields and the dollar extend recent declines after the Democrats’ blue sweep in midterm elections on Tuesday, 3 November, suggesting investors fear legislative gridlock will slow the AI investment boom that has powered US growth and interest rate expectations.
The Democrats’ margin of victory in the House and the Senate exceeded most forecasts, offering a market-moving surprise.
Investors have bought US government bonds, which lowers their yields, and sold dollars in the wake of the results.
Lower Treasury yields will ease global dollar borrowing costs, while the softer dollar offers corporates the opportunity to lock in the most favourable purchase rates since the beginning of October.
Markets are cutting expectations for Federal Reserve (the Fed) rate hikes, the main influence on the dollar, because they expect slower AI investment to cool the US economy.
“The market reaction has been risk-off, with the move appearing to be driven less by a higher political risk premium and more by renewed concerns around the AI and data centre investment buildout,” say analysts at Danish lender Danske Bank in a 4 November note.
Democrat Gina Hinojosa won the Texas governor’s race after calling for a moratorium on new data centres. Texas holds a heavy concentration of planned data centre projects.
The outcome of the vote is likely to shape the evolution of the AI investment boom, a central driver of US economic outperformance that has ensured inflation remains above the Fed’s 2% target.
However, AI doubts predate the election, with Alphabet and Amazon results last week raising fresh questions over whether AI spending will pay off.
Apple’s shares fell after the company guided to narrower profit margins. The Nasdaq 100 fell into a correction on 2 November, 10.36% below its 6 October peak.
“Concerns of an AI investment slowdown is calling into question the US growth advantage and dampening Fed rate hike expectations,” says Elias Haddad, Global Head of Markets Strategy at US private bank Brown Brothers Harriman.
Investors expect fewer Fed rate hikes
If the midterm vote gives markets reason to think policy will evolve to cool the AI buildout, the odds of further Fed hikes will ease, which would in turn weigh on the dollar, all else equal.
Investors cut the rate hikes priced by June 2027 to 0.55 percentage points after the result.
The Fed had already given investors little urgency, holding rates on 28 October in a 10-2 vote with Governor Lisa Cook and Cleveland Fed President Beth Hammack preferring a hike.
Fed Chair Kevin Warsh gave no steer on December, saying “I also don’t believe in prejudging meetings”.
Investors cut the odds of a December hike to 84% from 91% by the close of Fed day, and the odds stood at 78% ahead of the midterm election result. Those odds should recede further.
The two-year yield, which tracks Fed expectations closely, fell to 4.70% from around 4.77% before Warsh spoke, and it now stands at 4.60%.
Banks reported weaker demand for business loans, commercial property loans, and mortgages in the Fed’s latest lending survey, which analysts say shows tighter financial conditions are having an effect.
The dollar’s fall signals the market expects the stock market sell-off will help cool inflationary conditions in the economy by enough to limit the need for an aggressive Fed hiking cycle.
The euro has gained 1.2% and the pound 1.4% against the dollar since the eve of the Fed decision, taking EUR/USD to 1.1263 and GBP/USD to 1.3495. USD/JPY stands near 158.35, a touch higher over the same period.
Investors buy Treasuries on the prospect of less US borrowing
Research indicates no clear negative market impact of divided legislatures and suggesting this is a turning point for the dollar, treasuries, and equities would be premature.
However, there is an argument to be made that Treasuries can benefit as investors anticipate less borrowing and fewer tax cuts, as neither party has the ability to pass pet projects.
Investors began buying Treasuries before the Fed met, taking the 10-year yield from a 2026 peak of 5.36% to near 5% ahead of the decision.
The 10-year yield fell towards 4.90% as the election results came in, and it now stands near 4.93%.
Much will now depend on Iran and oil prices: Brent crude has fallen to around $104 a barrel on hopes of US-Iran talks, which eased fears of higher inflation and added to demand for bonds.
The dollar could lose its safe-haven support
The dollar is the world’s main safe-haven currency, and global investors usually buy it when stock markets fall, moving their money into US government debt and cash until the turbulence passes.
However, that protection can weaken when the trouble starts in the US, because foreign investors holding US shares then have their own reasons to sell dollars.
“When the source of an equity shock is US-centric, the dollar-equity correlation flips to positive,” say strategists at German lender Deutsche Bank in a 30 October note, meaning the dollar and US shares can fall together.
The implication is that dollar action into year-end could well depend on how the market performs: does the recent correction fade and buyers step in again, or will it be deeper as more heat comes out of the market?
Unhedged dollar trades are a vulnerability
Deutsche Bank estimates that foreigners own more than $20tr. of US shares, whose inflows are “currently financing the entire US current account deficit”, the bank says, referring to the gap between what the US spends abroad and what it earns.
Many of those investors have left their dollar exposure unprotected, because a stronger dollar has tended to cushion them when shares fell.
Should the sell-off continue, they could start to protect themselves by selling dollars, adding to the pressure on the currency, the bank says.
“The risks to the dollar are a lot more two-sided than the market has been pricing over the last few weeks,” it adds.
Kamakshya Trivedi and Michael Cahill, analysts at US investment bank Goldman Sachs, say in a 30 October note that the tech reversal is “unlikely to immediately provide a ‘safe haven’ boost to the dollar”.
They name the yen as a better hedge.