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If there's a big market reaction to the outcome of Tuesday's presidential and congressional elections, it probably will start in the

Treasury market.

The Treasury market is where benchmark interest rates are set -- depending in large measure on expectations for the supply of Treasury

bonds,

notes and

bills.

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For most of the last 25 years, the question about the supply of Treasury securities has been: How much will it grow? The federal government ran budget deficits, and it plugged them by issuing Treasury securities. Growing deficits and increasing supply of Treasury securities kept pressure on their prices. Bond prices didn't always fall, because they depend on more than just supply, but when they fell, benchmark interest rates rose.

This time, the question is different. In 1998, the federal government stopped running deficits and started running surpluses. And it has been using the surpluses to pay down debt by conducting

buybacks of long-maturity issues, and by issuing fewer new securities than it has old ones maturing.

As a result, the portion of the national debt that takes the form of Treasury securities outstanding has started to decline. The smaller supply of Treasury securities has increased their value, lowering benchmark interest rates by lowering yields.

And so the question this time around is: How much of the projected surpluses will survive the next administration? "For financial markets, the key question for this election is: What happens to the surplus?"

Lehman Brothers

economists Ethan Harris and Joseph Abate wrote in a recent report.

If there is a big reaction in the Treasury market to the outcome of the elections, it will be dictated by the assumptions people are making how the various possible outcomes will affect the projected surpluses.

Fondest Hope: Gore and a GOP Congress

The best outcome for the Treasury market, many economists and bond market analysts say, would be for Democrat

TheStreet Recommends

Al Gore

to win the presidential election and for Republicans to maintain their majorities in Congress. A Democrat in the White House and Republican control of Congress is the recipe that produced the surpluses, and that is likeliest to preserve most of them, experts say.

Any combination involving a Gore victory is probably better for the Treasury market than any combination involving a victory for Republican

George W. Bush

, economists and bond market watchers say.

That's based partly on precedent.

UBS Warburg

economists Maury Harris and Susan Hering point out that interest rates on average have been higher under Republican administrations. "History says that the fixed income markets should be more troubled if Republicans grab the presidency," they write.

But it's also based on the candidates' specific proposals. Both Gore and Bush would run smaller surpluses than are currently envisioned because they would both increase spending and lower taxes. But bond market analysts say the surpluses would be smaller under Bush than under Gore, because Bush is also proposing a plan to divert a portion of the Social Security payroll tax into private investment accounts.

Without any changes in current rates of spending and taxation, the federal government would run surpluses totaling $4.6 trillion over the next 10 years, according to the

Congressional Budget Office

. Regardless of who wins the election, the actual totals will probably be smaller. "Simply put, the current size of the surplus represents an irresistible temptation for politicians,"

Barclays Capital

economist Henry Willmore said in a research note.

But

Merrill Lynch

government bond strategists Gerry Lucas and Joe Shatz estimate that the projected surpluses will be $300 billion to $400 billion lower under Bush than under Gore. "Obviously, these differences in cash flows would have major implications for the buyback program and the scarcity premium factored into Treasury prices," they write.

Bond investors, UBS Warburg's economists say, believe that Bush's plan "would force the Treasury to scale back debt buybacks, lifting bond yields." By that logic, a Gore victory could give Treasury prices a boost, lowering interest rates, while a Bush victory could trigger a bond-market selloff, raising interest rates.

Scariest Outcome: The Sweep

The market reactions won't necessarily be sharp, however, unless the victor's party also gets control of Congress -- particularly of the House, where tax and spending bills originate, experts say.

"Gridlock in Washington has helped ensure the continued piling up of surpluses," the Lehman economists note. "The biggest risk to this outlook is a clean sweep by one of the parties,

which could be taken as a mandate to implement campaign promises aggressively." Bond investors would anticipate not only that buybacks would be curtailed, but also that stimulative fiscal policies -- tax cuts and spending increases -- would be countered by the

Fed with more restrictive monetary policy (i.e. a higher

fed funds rate), in order to keep inflation in check.

"The strongest potential adverse bond market reactions probably would come with strong presidential and congressional victories for either the Democratic or Republican parties," UBS Warburg's economists agree.

Another Possibility: The Blank Stare

At the same time, there are plenty of reasons why the markets shouldn't react to the election outcome, regardless of what it is, economists and bond market analysts say.

Even if the same party wins the White House and Congress, the closeness of both races in the polls suggests that the election is unlikely to produce a clear mandate, some say.

"In the absence of a major landslide and congressional sweep, a certain amount of legislative gridlock is likely to persist," says Ken Mayland, chief economist at

ClearView Economics

. "Hence, the bias will be to sustain large budget surpluses, which is to say, the national debt will continue to be rapidly paid down."

Reacting to Tuesday's results, UBS Warburg's economists note, assumes that the victor's policies will be enacted. "Market participants would be wise," they say, "to maintain a healthy sense of skepticism" about that. In any event, these things take time, they point out. For example, tax cuts probably won't take effect till 2002.

Perhaps the best reason for bond investors to refrain from moving the market in reaction to the election results is that they haven't proven particularly adept at it lately, Barclays' Willmore says.

In 1992 and 1994, it took the bond market six months to price in the tightening of fiscal policy that those elections brought about. The precedents suggest, Willmore says, that "the reaction will not come immediately after the election but rater over a period of months as the market assesses how serious

the victor is about implementing the program he campaigned upon."