U.S. President Joe Biden's exit from the presidential race on Sunday could prompt investors to unwind trades betting that a Republican victory would increase U.S. fiscal and inflationary pressures, while some analysts said markets could benefit from an increased chance of divided government under the next administration.

The so-called Trump-trade, which presumes the former president's tax policies will lift corporate profits, while undermining the country's long-term budget health, gained ground following Biden's disastrous TV debate last month.

It was especially visible in U.S. government bonds, with long-dated Treasury yields − which move inversely to prices − briefly rising on increased expectations that Republican presidential nominee Donald Trump would regain the White House after the debate and last weekend's assassination attempt.

Although yields quickly retreated on signs of economic weakening, the move reflected investors' belief that a Trump presidency could lead to inflationary policies and a more fiscally expansive stance. But Biden's decision to step aside and endorse Vice President Kamala Harris to replace him as the Democratic candidate casts doubt over a Trump victory and will likely prompt investors to pare those bets.

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Trump's team has said his pro-growth policies would bring down interest rates and shrink deficits. Many market participants believe deficits will keep deteriorating under a second Biden administration as well.

"It does take some of the wind out of the sails of the Trump Trade," said Cameron Dawson, CIO of NewEdge Wealth in New York, although she said markets would be waiting for more clarity about who the nominee will be.

"That's when we might look for the reversal of the Trump Trade and other kinds of movements," said Dawson.

A Reuters/Ipsos poll that closed on Tuesday found Trump had a marginal lead among registered voters − 43% to 41% − over Biden.

When accepting the Republican nomination on Thursday, Trump again pledged to cut corporate taxes and cut interest rates. Analysts also expect a Trump presidency would make for tougher trade relations, which could result in inflationary tariffs.

Lower tax revenues could widen the U.S. federal government's budget deficit, which has risen steadily for much of the past decade, including under Trump's previous 2017-2020 presidency, although a spike in 2020 was mostly driven by COVID-19 government relief.

Many investors believe the deficit will keep deteriorating under a second Democratic administration too, but a more balanced election result could reduce the risk of the excessive fiscal stimulus expected if Republicans sweep Washington.

Divided or clean sweep?

Congress is currently divided, with the House of Representatives narrowly controlled by Republicans and the Senate by Democrats. A divided government is often seen by investors as positive for markets, because it makes it harder for either party to force through dramatic policy changes.

Several Democrats had warned that Biden's initial refusal to step aside, which led some Democratic donors to shut the spigots, would wipe out Democrats in House and Senate races too. Biden's exit, however, would increase Democrats' chances of controlling at least one of those chambers, said Brij Khurana, fixed income portfolio manager at Wellington Management Company, speaking ahead of the announcement.

"A divided government, if it does materialize, would mean much lower yields than we currently have," said Khurana, as bonds would reflect a potentially more benign outcome for government debt issuance.

Jamie Cox, Managing Partner of Harris Financial Group, said markets might now reprice what had previously been expected to be a sweep of Congress.

"The Senate is very likely to go Republican but the House of Representatives is very vulnerable to a Democrat takeover," said Cox.

Jack McIntyre, portfolio manager, global fixed income, Brandywine Global Investment Management also referred to a divided government as a potential outcome and "a positive for the market."

Volatility expected

Investors said that market volatility could increase as the uncertainty over the election continues.

"Biden stepping down is a whole new level of political uncertainty," said Gina Bolvin, President of Bolvin Wealth Management Group. "This may be the catalyst for market volatility that is overdue."

Swathes of the equities market, in particular small caps, have reacted favorably in recent weeks to the prospect of a Trump win. Cryptocurrencies have also rallied on inflation bets.

The Cboe Volatility index − Wall Street's "fear gauge" − touched its highest level since late April on Friday.

“The market doesn’t like uncertainty, and the added element of an unknown Democratic nominee will certainly add to investor discomfort," said Rafia Hasan, Chief Investment Officer, Perigon Wealth in Chicago. "We don’t know what the market will do tomorrow and into the coming weeks with this news, so investors should sit tight."

Reporting by Davide Barbuscia, Ira Iosebashvili, Matt Tracy, Suzanne McGee, Svea Herbst-Bayliss, Caroline Valetkevitch, Carolina Mandl, Saeed Azhar, Amanda Cooper; editing by Michelle Price, Megan Davies and Aurora Ellis