The market has been focusing on the U.S. presidential election to be held tomorrow since the results will affect outlooks for different key issues "ranging from the fiscal cliff resolution to the Federal Reserve leadership," according to Bank of America Merrill Lynch report released on Friday.

Analysts expect that there might be volatility in rates and agency MBS. They are currently staying with their neutral recommendation and cited the favorable technicals that they expect will push credit spreads tighter unless a broader risk-off trend happens.

They added that the risk of rate volatility is still binary in terms of election results and they are staying with their duration neutral bias. They added that the knee-jerk move higher in rates if Mitt Romney wins will probably be bigger versus the move lower if President Barrack Obama gets re-elected for a second term.

The election's implications in terms of resolving the fiscal cliff are considerable. A Republican sweep or Romney win with a split Congress can lessen the chances of a fiscal cliff in the near-term and rates should also increase, analysts said.

However, if the elections result in an Obama win with a split Congress, this can mean that a political gridlock might go on and the resolution to the fiscal cliff will not be as easy. Analysts expect rates to head lower if this happens.

In terms of the MBS markets, analysts said that MBS markets are still considerably vulnerable to volatility from election results. They are keeping their neutral bias on the asset class.

They also think that the election outcome will have different effects. These can range from a short-term effect on MBS valuations to the medium-term outlook for leadership shifts at the Federal Housing Finance Agency (FHFA) and the Federal Reserve, and the consequent impact on current and new regulatory initiatives.

Beyond the effect of changes in rates and volatility, the election could also cause investors to reassess the duration of Federal Reserve purchases under the QE3, analysts noted. If Romney wins, he probably will replace current Fed Chairman Ben Bernanke at the end of his term in January 2014.

Analysts said that under both election outcomes, they think that the Federal Open Market Committee’s support for QE3 should stay put through 2013. But, they said that the chances for Fed MBS purchases to extend well into 2014 are better in an Obama Presidency.

They added that an Obama win also holds the prospect for more housing stimulus. The Obama administration can replace FHFA acting director Edward DeMarco, who has gone against a lot of the White House's stimulus measures. The replacement can open the door for the FHFA to facilitate further refinancings, loan modifications, principal forgiveness, non-agency to agency refinancings, among others, BofA Merrill said.

This type of stimulus can serve as a positive for housing and the non-agency MBS market, analysts noted.

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