The question on everyone's mind this morning is what will happen this week? What of the election, the Fed, the economic statistics?
In time we may look back and see that now was the time when the public began to appreciate the increased U.S. policy uncertainty and government instability... which argues for longer term caution in holding U.S. assets.
from Ken Landon, J.P.Morgan Strategy, NY (Nov 1, 2010)
* EVENT RISK - This week headlines plenty of headline risk for the markets. To name a few: 1) US mid-term elections on Tue; 2) RBA policy decision on Tue; 3) FOMC announcement on Wed; 4) BoE & ECB policy decisions on Thu. Payrolls on Friday seem minor in comparison.
* FED - Expectations in the market likely are centered on the FOMC announcing $500 billion of UST purchases over the course of six months. That is the view of JPM and it is cited in the press as representing the median expectation of many economists. Like all FOMC statements, it will be crucial for the market reaction to see the way in which the Committee expresses its guidance for future policy. One key passage will include whether or not the Fed leaves open the door to future increases in debt monetization above the initial amount announced on Wed. In any case, you no doubt already know all of this because of repeated mentions in the press and, no doubt, every bank that sends out research. One thing that is clear to me: the Fed has significantly increased Policy Uncertainty in the eyes of investors and business decision-makers. Monetary policy is now a crap-shot when it comes to investing one's capital.
What is the Fed accomplishing by its widely-telegraph intent to print up more fiat paper cash and aggressively monetize UST debt? The central bank has significantly boosted market expectations of inflation while simultaneously lowering Real Rates. Attached chart 10Y_BE.gif shows that the 10Y Inflation Breakeven priced in the bond market has risen sharply since August and is now above historic averages. At 2.17%, the 10Y Breakeven is above the 1998-2010 average of 2.0% and the 1998-2008 average of 2.06%. The same is true for the 5-year, 5-year forward Inflation Breakeven, which is currently 2.88% vs. the 1999-2010 average of 2.64%.
Chart SILVER.gif shows that the price of silver has risen to 30-year highs. Lumber is at the highest levels since May and copper is close to cyclical highs. The USD is weakening once again after it rebounded over the past two weeks when the market started to question its assumptions about the size and duration of the anticipated debt monetization of the Fed.
It is hard to predict how financial markets will react in the immediate aftermath of the FOMC meeting on Wed. It could turn out to be a classic "buy the rumor, sell the fact" situation, but the consolidation of the previous two weeks suggests that such unwinding already has occurred to some extent. If I were a betting man, then I would leave the casino right now and come back after the possible carnage. As mentioned above, monetary policy and its effect on the economy and the marekts has been reduced to a crap shoot. Uncertainty is unusually high. In this highly uncertain monetary environment, it is not a surprise that expectations are rising about future inflation. Such uncertainty will work against the USD. Capital will seek out more stable monetary environments in the newly emerged economies of the world. Capital will exit the newly submerging economies.
* ELECTION - The market likely is pricing in a Republican victory that gives the Party control of the House and a pick up of around seven seats in the Senate. The most likely outcome of such a configuration in Congress will be political gridlock. Business decision-makers may find gridlock preferable to the recent steamroller approach to ruling the nation. However, it is important to understand that legislative action will be required to avoid a very negative result for the economy in 2011. Specifically, if Congress does not pass a bill that the President is willing to sign, rates of income taxation will increase as of January 1st.
In that respect, a story in the Washington Post holds out hope that the current Congress may accomplish something of real value for the economy. Specifically, the Post reports:
"According to people familiar with talks at the White House and among senior Democrats on Capitol Hill, breaking apart the Bush administration tax cuts is now being discussed as a more realistic goal. That strategy calls for permanent extension of cuts that benefit families earning less than $250,000 a year, and temporary extension of cuts on income above that amount."
If Congress were to pass such an extension of the Bush tax cuts and if the White House were to sign it, then two things would have been accomplished: 1) Elimination of uncertainty about future taxes that now overhangs decision-making; and 2) Avoidance of growth-destroying tax hikes that would transfer valuable capital from productive individuals and businesses to the government.
Before ending today's comment, my scanning of the web indicates that people are finally starting to talk about the possible implications for Fed policy resulting from a possible Republican takeover of the House. Cutting right to the chase, ZeroHedge.com reports:
"The Fed will be hamstrung, as Ron Paul, a conservative standard-bearer and harsh critic of the Fed, will head the sub-committee overseeing its actions. Liquidity expansion or new programs will probably drop sharply under his watch."
To give an idea of the kind of testimonies that Chairman Bernanke may be subjected to under the tutelage of Ron Paul, consider the following exchange between the latter and former Chairman Greenspan during congressional testimony in 2004:
RON PAUL: "Maybe there is too much power in the hands of those who control monetary policy, the power to create the financial bubbles, the power to maybe bring the bubble about, the power to change the value of the stock market within minutes? That to me is just an ominous power and challenges the whole concept of freedom and liberty and sound money."
ALAN GREENSPAN. "Congressman, as I have said to you before, the problem you are alluding to is the conversion of a commodity standard to fiat money. We have statutorily gone onto a fiat money standard, and as a consequence of that it is inevitable that the authority, which is the producer of the money supply, will have inordinate power."
If the Republicans take the Hosue and if he sets the agenda in Sub-Committee, then Ron Paul will no doubt shine the spotlight on Mr. Bernanke as the Fed embarks on QE2. The potential for increased volatility in the financial markets will increase on Nov 2nd and when the new Congress convenes in January.
