'We Live in Interesting Times"

Sydney M. Williams

Thought of the Day

“We Live in Interesting Times”

October 14, 2010

As we head toward the end of the year, there are three external events to which attention should be paid. The first will be the election on November 2nd, which is widely expected to increase Republican’s representation in Congress, possibly giving them control of the House. To me, that seems a stretch, but the super majority that Democrats have enjoyed for the last two years will be gone. The second event will be the Federal Reserve Open Market Committee meeting on November 2nd & 3rd. Their statement will be released on the 3rd of November, the day after the election. The third event will be a vote in Congress on extending the Bush tax cuts, at some point before the year end.

As regards those external events, the market seems to be expecting that Republicans will take control of the House; that the Federal Reserve will express a willingness to further expand quantitative easing, and that the Bush tax cuts will be extended for all except the wealthiest.

Perhaps that is still the most likely outcome. However, it is possible that the market may not be discounting the domino effect of a Republican victory. Should the Republicans do better than expected in the election – not my expectation, but a possibility – it could be that fiscal conservatives within the Fed may influence the others to back off on further easing – or, at least to postpone a decision until the December meeting. And, if Republicans take control of the House, Democrats may extend the Bush cuts for all parties, based on the concept that any tax increase during tough economic times is never a good idea, enacting them as the “Obama” tax cuts.

The odds, in terms of the Republicans taking control of the House, may be less than 50%, but they are probably not as low as 30%. The question then: how will markets react?

In my opinion, which should always be taken with a hefty dosage of salt, bonds would fall (interest rates would rise) and stocks would fall, at least immediately. The expectation of persistent low rates seems to be built into the stock market, and many managers believe that continued easing is key to avoid dipping back into recession.

However, for several reasons, a Federal Reserve that remains “accommodative”, but avoids “QE2”, I believe would be better for stocks and the economy, though it could signal an end to the Treasury rally. Despite the better than 12.5% rally since the end of August, domestic equity mutual funds continue to get redemptions. Uncertainty as to the economy and the fate of tax rates continue to weigh on investors.

Chairman Bernanke will be speaking tomorrow morning at 8:15AM at the Federal Reserve Bank of Boston Conference. The title of his speech: “Revisiting Monetary Policy in a Low Inflationary Environment” – certainly not propitious for tightening and likely not for continuing the current path of accommodation. Everybody expects a new round of quantitative easing, but rates, including mortgages, are already at historic low levels. It is not interest rates that are hurting the housing market. It is the lack of confidence in the economy and the seemingly inability of our politicians to fix things that are forestalling recovery in housing. The foreclosure mess (as I wrote on Monday) is just a further example of the way in which politicians insert themselves into a problem that the private sector was already correcting.

Additionally, low interest rates are nurturing what could be future problems. Energy and food costs are up and returns on savings are down – taxing the poor and limiting investment returns for the elderly, not a happy scenario for a Party that claims to look after those groups.

Nevertheless, it is possible that a Republican victory could set off a chain of events that might smart in the short term, but could be positive as we go through 2011. Even the Federal Reserve may not be immune.