US elections can have a significant impact on financial markets, not only because they determine who controls the government but also because they influence expectations about future fiscal policy. One of the most important aspects of the US political system is that Congress controls the government’s spending and taxation decisions, giving election outcomes the potential to reshape the economic outlook.
When one party controls both chambers of Congress, passing legislation can become easier. Conversely, divided government, where different parties control the presidency, the House and/or the Senate, can create political gridlock and make major fiscal changes more difficult. These political dynamics matter because fiscal policy influences economic growth, inflation, government borrowing and, ultimately, the Federal Reserve’s monetary policy outlook.
How congress controls fiscal policy
The US Congress plays a central role in determining fiscal policy through three main channels: government spending, taxation and borrowing. It approves federal spending through appropriations legislation, determining how much money is allocated to areas such as defence, infrastructure, healthcare and social programmes. The President can propose a budget, but Congress ultimately decides what spending legislation to pass.
Congress also determines federal tax policy. Changes to corporate taxes, personal income taxes and other forms of taxation can influence household consumption, business investment and government revenues. Tax legislation must pass both chambers before being sent to the President.
When federal spending exceeds tax revenues, the government runs a budget deficit and needs to borrow to finance the difference. Congress authorises borrowing and controls the statutory debt ceiling, while the Treasury manages the issuance of government securities. These three channels are closely interconnected. Higher government spending or lower taxes generally increase the fiscal deficit unless offset by other measures, while spending cuts or tax increases can reduce borrowing requirements.
Why divided government can limit fiscal expansion
When the President’s party does not control both chambers of Congress, passing major fiscal legislation becomes more difficult. For example, a Republican President seeking additional tax cuts or higher defence spending may struggle to secure approval from a Democratic-controlled Congress. The opposition can block legislation, demand concessions or negotiate changes that reduce the overall fiscal impact.
This can create a more restrictive fiscal environment, with fewer opportunities for large spending packages or additional tax cuts. However, divided government does not automatically mean fiscal contraction. Congress can still reach bipartisan agreements, particularly on politically important areas such as defence spending, infrastructure and disaster relief. Existing spending programmes also continue unless legislation changes them.
Congressional control, however, does not give Congress complete control over the President’s foreign or trade policy. The President retains significant executive authority over tariffs and military operations, although Congress has important constitutional powers over trade regulation, declarations of war and government funding. A divided Congress can constrain domestic fiscal expansion without necessarily preventing the administration from pursuing its broader geopolitical or trade agenda.
How congressional control influences financial markets
The implications for financial markets depend on how traders interpret the resulting fiscal outlook. The same political outcome can affect different asset classes in different ways.
Treasury yields
Government borrowing is one of the most direct channels through which fiscal policy affects bond markets. More fiscal expansion generally means higher government spending, larger deficits and potentially greater Treasury issuance. If markets expect increased borrowing, they may demand higher yields to absorb the additional supply of government debt. Fiscal expansion can also support economic growth and increase inflationary pressures, potentially pushing real and nominal yields higher.
Conversely, expectations of fiscal restraint can reduce projected borrowing requirements and inflationary pressures, creating room for Treasury yields to decline. However, if fiscal restraint is expected to weaken economic growth, markets may increase demand for government bonds, pushing yields lower even without a meaningful reduction in Treasury issuance.
The US dollar
The dollar is influenced by several factorsl like economic growth expectations, capital flows and risk sentiment. The most important, though, is interest rates expectations.
Fiscal expansion can support the dollar if it strengthens economic growth and pushes Treasury yields higher as Federal Reserve rate hikes become more probable. Fiscal restraint can have the opposite effects. Lower borrowing expectations and reduced inflation pressures may weigh on Treasury yields and interest rate expectations, making the dollar less attractive, especially at overstretched levels.
Equities
The impact on equities is more nuanced because different sectors respond differently to fiscal policy. If we look at the broader stock market, the impact is mainly on growth expectations. Fiscal expansion generally supports aggregate demand, benefiting companies through stronger consumption, investment and government contracts. Tax cuts can also increase corporate profitability by reducing the tax burden on businesses.
Conversely, fiscal restraint can weigh on economic growth and corporate earnings, particularly in sectors that depend heavily on government spending or domestic demand. However, lower Treasury yields can provide some support to equities by reducing the discount rate applied to future corporate earnings and making bonds relatively less attractive. This means that a politically driven decline in yields can support equity valuations even if the underlying fiscal outlook becomes less favourable.
Why markets react to expectations rather than actual policy changes
One of the most important concepts in trading is that financial markets are forward-looking. Traders do not wait for legislation to be passed before adjusting their positions. They continuously assess the probability of different political outcomes and incorporate those expectations into asset prices.
For example, if markets expect that a divided Congress will prevent additional tax cuts and spending increases, Treasury yields and the dollar may start declining before any fiscal legislation changes.
Positioning also matters. If investors are heavily positioned for a particular political or economic outcome, even a relatively modest change in expectations can trigger significant price movements as those positions get unwound.
This article was written by Giuseppe Dellamotta at investinglive.com.