US: Investors not as concerned about Trump winning as it may seem at first blush - BBH

Research Team at BBH, suggests that while risk assets were being sold and the security of fixed income was sought, there were two market developments that suggest investors are not as concerned about Trump winning as it may seem at first blush. 

Key Quotes

“First, the Mexican peso has been sensitive to the vagaries of the US election campaign.  For several weeks, when Trump's comments saw his standing fall, the Mexican peso staged a strong recovery and was best performing currency last month (2.75%).  However, as Trump began doing better, the US dollar rallied 5.75% against the peso (October 25-November 3).

The US dollar posted a big outside down day against the peso on November 3.  It traded above the previous day's high.  It proceeded to reverse and settled below the previous day’s low.  There was following through dollar selling of the peso the following day as well.  The peso was the strongest currency before the weekend.  It appreciated nearly 0.8%.  Despite what may have been interpolated from the equity market slide, if market participants really feared a Trump victory was likely, the peso would have sold-off, or at the very least, underperformed.  As it is, the peso has gained today on the FBI news.

The second important instrument that is telling us investors think a Trump victory is unlikely is the December Fed funds futures strip.  The hypothesis is that news of a Trump presidency would roil the markets.  This market volatility would likely reduce the chances of a Fed hike next month.  If one thought that Trump would win, the peso would be lower, and the Fed funds futures would not be so steady.

For the last 12 sessions, the December Fed funds futures have been closing between 49.5 bp and 50.5 bp (recall that the bid-spread offer is half a basis point).  Bloomberg calculates this to be a 76% chance of a hike, while the CME estimates the odds at 66%.

Our own work is in line with Bloomberg's estimate.  Recall the futures contract settles at the average effective Fed funds rate for the month.  What will be that average in December?

For the first 14 days, let's assume Fed funds averages what it has been in recent weeks, 41 bp. Let's assume the Fed hikes on December 14, and on December 15, Fed funds average the midpoint of the new range (50-75 bp) of 63 bp.  However, due to the quarter- and year-end, the Fed funds rate will likely fall on Friday, December 30.  The Friday rate applies to Saturday, December 31 as well.  A reasonable and conservative estimate is that the effective average will slip 15 bp to 48 bp.

Add those products together (14*41) + (15*63) + (2*48) and divide by the 31 days of the month, (49.5 bp).  The December Fed funds futures contract has discounted 76.5% of 25 bp hike in the target range.”