How the 2022 Midterm Elections Can Affect the Bond Markets

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The 2022 midterm Congressional elections are finally over.

So, if you are a bond market professional, what does this mean and why should you care?

Elections do have consequences. Political shifts lead to policy changes that not only affect real people, but can affect various sectors of the business community, financial markets, state and local governments and, most particularly, the highly regulated financial services industry.

This article will breakdown how financial regulatory, tax and Treasury market debt management policies could be affected by the results of the 2022 midterm elections.

US House of Representatives (“House”)

The Republicans taking over the majority in the House is a material change. Even with a very slim nine-seat majority, without a filibuster rule that typically hamstrings the US Senate, a simple majority is all the controlling party in the House needs to stop debate, pass a bill and change a rule. That gives the majority party tremendous power…so long as their agenda is supported by 218 members of the House (a majority).

Party discipline has been challenged in both parties, as we have seen the more ideological wings of both the Democratic and Republican parties assertively flex their muscle in the House. The expected (as of this draft) incoming Speaker of the House, Congressman Kevin McCarthy (R-CA), will have his hands full ensuring that his party’s legislative priorities have the votes necessary to advance. Although the actual vote for the next speaker occurs on January 3, 2023, Cong. McCarthy was nominated by his Conference by a vote of 188-31. It is those 31 “NO” votes that could challenge the smooth sailing for the House Republican agenda.

US Senate

The US Senate will remain in Democratic control except, beginning on January 3, instead of a 50-50 split with Vice President Kamala Harris having a tie breaking vote for the Democrats, the Democratic Caucus will consist of 51 Senators. That includes three Senators who identify themselves as “Independents” but have chosen to caucus with the Democrats.

In the US Senate, during 2021-2022, the 50-50 split resulted in each of the Committees of the Senate having equal representation of both parties, making it much more difficult for Democratic Chairs to move legislation, conduct investigations and move nominations (particularly judicial nominations). As a result of the recent runoff election in Georgia, next year the Democrats will have a majority on each Committee. That is an important difference as it relates to policy, oversight and nominations.

Financial Regulatory Policy in 2023

Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), financial institutions, products and the cash and derivatives markets have experienced fundamentally more regulatory oversight. More recently, in 2022, the Securities and Exchange Commission (“SEC”), under the leadership of Chair Gary Gensler, advanced 35 regulatory proposals.

These include:

Reg ATS for US Government Securities
Shortening the Settlement Cycle
ESG/Climate Related Disclosures
Clearing Agency Governance
Treasury Market Clearing
Best Execution Rule Covering Fixed Income
Time Relief on Apply Rule 15c2-11 to Fixed Income (No action letter)

Chair Gensler and other financial regulators nominated by President Biden have two years remaining in the Administration’s first term. The election results of 2024 are too uncertain for them to put off something that they can do now. Expect to see the pace of rule-making coming out of financial regulators to be brisk.

Congressional Oversight

Congressional oversight is a check against overly aggressive regulatory policies.. As a result of the Republican House majority, every committee and subcommittee Chair in the House will be a Republican. They will have the power to set their legislative and oversight agendas and the power to call oversight hearings or initiate investigations about any agency or issue under their jurisdiction. They can also issue subpoenas to compel witness testimony.

This means that the relevant committees of the House will use their power to oversee the policies of President Biden’s financial regulators. The House Financial Services Committee, under the leadership of incoming Chair Congressman Patrick McHenry (R-NC) can be expected to use this oversight power to challenge policies coming out of the financial regulators, including the SEC, Federal Housing Finance Agency, Consumer Financial Protection Bureau and banking regulators.

Also, expect to see investigations into the expenditures by states and localities and other recipients of Covid assistance funds coming out of the CARES Act and the American Rescue Plan.

The Ultimate Oversight

The new Republican House will have tremendous oversight capabilities to hold President Biden-appointed regulators accountable for their decisions. But, it is also important to be cognizant that we remain, at least for the next couple of years, in an environment where Federal regulators may be aggressively interpreting their statutory authority while there is a Judicial Branch that is currently more conservative and textualist in their view of statutory interpretation. This could lead to more administrative challenges to agency actions.

Legislation

During 2021-2022, with the White House, a slim majority in the House and a 50-50 Senate (with the tie breaking vote), the Democrats were able to pass and enact two pieces of significant legislation through the “reconciliation” process. Subject to significant budget rules, this process allows the Senate to pass legislation in an expedited manner that is not subject to a filibuster. 60 votes are required to end a filibuster. Therefore, with only a simple majority (51) of the Senate the American Rescue Plan (2021) and the Inflation Reduction Act (2022) were enacted. During the Trump Administration the Tax Cuts and Jobs Act of 2017 (“TCJA”) was passed through this process when the Republicans had majorities in both the House and the Senate.

The change in control of the House makes the reconciliation process much more difficult to utilize. Therefore, unless the legislation is “must pass” (e.g. government funding) or non-controversial and broadly supported, expect to see legislation advance through the Republican controlled House that represent “messaging” bills that are consistent with their priorities, with little expectation that the Democratic controlled Senate will act on such measures.

Financial Regulatory

It is expected that for the House to pass legislation, they will have to have the support (or at least not the opposition) of the more conservative members of the Republican Conference. While that would not necessarily preclude bipartisan support, it is likely that there will be several legislative initiatives in the financial regulatory space that could roll-back provisions of Dodd Frank, or overturn Biden Administration regulatory initiatives. Such “messaging” legislation could pass the House, but likely die in the Senate.

The one area where there could be bipartisan legislation relates to regulating the cryptocurrency/digital asset sector. The recent developments involving FTX have already generated Congressional reaction leading to Democrats and Republicans working together on legislation. In the words of then Cong. Rahm Emanuel just before becoming President Obama’s first Chief of Staff in the midst of the credit crisis when describing their goals for serious and aggressive financial regulatory reform, “you never want a serious crisis to go to waste.”

Municipal Bonds

There remains a long list of unfinished business in the municipal bond space. State and local government groups, working together with BDA, have been advocating for tax proposals reinstituting advance refunding bonds, expanding bank qualified bonds, as well as other pending issues. Many of those provisions were revenue raisers in the Tax Cuts and Jobs Act of 2017. While protective of TCJA, Republicans are also mindful that several of its provisions will expire in 2025. While more likely to wait until after the next Presidential election, items like these could be a part of a broader tax package between now and then.

Would the Congress Risk a US Government Bond Default?

Another issue that could affect capital markets is the politically painful exercise of increasing the debt limit. It is a technical matter that must be done to ensure the US Treasury can continue to issue bonds to meet the government’s obligations. However, Members of the Congress do not like voting to increase the debt limit. Therefore, historically, debt ceiling increases have been attached to other “must pass” legislation that can be done in a bipartisan manner. In the current environment, particularly in the House, such bipartisanship could be unachievable. Failure to pass the debt ceiling has significant ramifications on the Treasury and all financial markets. This will be something to watch carefully.

Conclusion

The Congress writes the law, the Executive Branch implements and enforces the law and the Judicial Branch interprets the law. As a result of the midterm elections, at least two of the branches (Legislative and Executive), and perhaps the third, will be intensely intertwined. Will regulators push their agendas more cautiously or more aggressively? Will Congressional oversight slow or accelerate the regulatory agenda? Can Congress and the Biden Administration come together on crypto regulation? Will the Courts overturn policies or actions of financial regulators?

These, and so many other questions, demonstrate why elections do matter and why people working in the financial markets should care.