Democratic presidential candidate Hillary Clinton celebrates on stage during her primary night event at the Duggal Greenhouse, Brooklyn Navy Yard, June 7, 2016 in New York. Timothy A. Clary | AFP | Getty Images

Wall Street is pricing in a landslide victory for Hillary Clinton, but if she starts to lag, there could be a big unwinding of stock and bond market positions, according to Bank of America Merrill Lynch's David Woo. Woo said the market is also pricing in a split Congress, with Republicans controlling the House and Democrats the Senate. That would maintain the deadlock in Washington. "You have a Democrat president, and a Republican controlled Congress which means you have gridlock in Washington. The market is pricing in this gridlock, meaning it's going to be that much of the burden of supporting the economy falls on the Fed," said Woo, head of global interest rates and foreign exchange strategy. That makes it harder to get agreement on changes in tax policy or for fiscal spending that could help the economy.



Woo said gridlock makes it hard for the Federal Reserve to raise interest rates very much, and that means the U.S. markets would continue to feel the benefits of the quantitative easing being done by other central banks. Central bankers in Europe and Japan have driven interest rates lower or negative, and investors have flocked to the U.S. credit and stock markets. Woo said that environment has led to the dominance of the risk parity trade, where investors see conditions that favor both stocks and bonds. "The market is pricing in gridlock and Goldilocks, and the gridlock is good for risk parity. The point here is as we go into Election Day, whether you're basically supporting Hillary or Donald Trump, it doesn't matter. History tells us volatility goes up in the final stretch. The VIX has always gone up in the final month. It's a general rule, rather than exception," Woo said. That could create some unwinding of positions, but a jump in the polls by Trump could also have an impact. "I'm not saying a market crash, but we could get a jolt, more than a jolt," he said. Risk parity portfolios are favored by hedge funds and can be highly leveraged. Woo said the volatility market is underpricing the election risk. "My point here is there's a very good chance Hillary's lead is going to narrow and volatility is going to go up as we head into September and October. That is going to be a shock to the market, and risk parity trades hate volatility. We saw that on this past Friday — bonds sold off and stocks sold off. That's the kind of situation that becomes self-fulfilling," he said. "Woo said there were two instances in the past five years where there was a big unwinding of the trade — in the 2013 "'taper tantrum" and last August when China devalued its currency. "If you think about the most crowded trades in the world right now, the most crowded trades are risk parity trades," he said. "The biggest positions are risk parity positions and it's done on a very leveraged basis."