Citi sees bond rally as divided government odds reach 48%

Prediction markets now price a 48% probability of a Democratic sweep in November's midterm elections, and Citigroup's quantitative strategy team says a divided government scenario points to a sustained rally in U.S. Treasuries.

"A divided government reduces the likelihood of new fiscal expansion, causing term premiums to fall," Citi's Quantitative Global Macro Strategy team wrote in a report published Aug. 14.

Polymarket odds show an 88% probability of Democrats winning the House and 53% for the Senate, while Kalshi assigns 85% to a Democratic House. Citi's base case is a "Blue House, Red Senate" outcome, with the market assigning 86% probability to Democrats controlling the House and 55% to Republicans retaining the Senate.

The stakes are significant for fixed-income investors. Since 1960, there have been eight midterm elections held under unified government, and five resulted in a divided government post-election. In those scenarios, 10-year and 30-year Treasury rallies have been more sustained, with the 2s10s spread typically flattening for about 50 trading days after the vote.

The report, which aligned midterm elections since 1960 on a unified event timeline, found that the S&P 500 often begins to draw down approximately 55 trading days before the election. If the ruling party maintains a "trifecta" — control of the presidency and both chambers of Congress — the median pre-election decline historically approaches 10 percent. However, prediction markets currently favor a shift of the House to Democratic control, making that more pessimistic scenario less likely as the base case.

Citi breaks the period from now through year-end into four trading windows. The first phase, T-60 to T-30 days before the election, sees uncertainty premiums rise, stocks prone to pullbacks, and implied volatility gradually increasing. The second phase, T-30 to Election Day, often brings an early relief rally as event risks become fully priced in, with volatility typically peaking around one month before the vote.

Bonds offer the clearest expression

In Citi's cross-asset framework, the rationale for bonds is the most direct. Yields on 2-year, 10-year, and 30-year Treasuries are generally lower after a lost trifecta, with post-election rallies in the 10-year and 30-year tenors being more sustained. However, the dynamics across the curve are not uniform. The 2s10s spread typically flattens before the election and continues this trend for about 50 trading days post-election, before steepening again; the 5s30s spread is more likely to steepen before the election and re-flatten afterward.

Three variables in 2026 could render historical patterns obsolete: persistently high fiscal deficits, next year's debt ceiling negotiations, and policy uncertainty stemming from the new Federal Reserve chair. If long-end yields continue to rise even after a divided government is confirmed, it would indicate the market is pricing in higher fiscal and inflation risk premiums rather than legislative gridlock.

Equity rotation favors cyclicals after the vote

The most counterintuitive conclusion within equities is that defensive factors are not suitable for continuous holding. The Quality factor typically performs well before the election but reverses sharply within 50 trading days afterward. Low Risk also tends to underperform during market recoveries due to its inherently lower or even negative market beta.

Both Value and Growth may weaken initially after the election, but Growth often recovers between T+50 and T+75. At the sector level, Technology has been the most obvious relative winner post-election, followed by Industrials; defensive sectors such as Healthcare, Consumer Staples, and Utilities are more prone to underperformance.

In foreign exchange, the U.S. Dollar Index tends to be generally weaker during midterm election years, but performance varies significantly across specific currency pairs. USD/CAD typically strengthens starting 50 trading days before the election and peaks around 40 days after. The Mexican peso behaves conversely, with USD/MXN continuing to decline in trifecta-loss scenarios. EUR/USD remains choppy around the election, with a clearer strengthening trend emerging only about 75 trading days post-election. Gold shows limited differentiation based on election outcomes, oscillating before the vote and performing roughly in line with or slightly better than normal afterward.

Citi cautions that the sample size is smaller than charts suggest — there are only 16 complete midterm election samples for the S&P 500, with divided government occurring just five times. A divided government may also fail to constrain executive power, as tariffs, trade policy, and geopolitical agendas can still be advanced through executive authority. And contentious debt ceiling negotiations next year could create fiscal risks that override the historical bond rally pattern.

The midterm elections should not serve as an independent buy or sell signal, Citi said. The correct approach is to first prepare scenario analyses, then validate them using price action, volatility, interest rates, and market breadth.

This article is for informational purposes only and does not constitute investment advice.