Saturday, January 22, 2011

Markets React Cautiously Positive to Elections, Await Fed

Global financial markets have not reacted decisively to the U.S. midterm elections, and that’s because a lot of folks aren’t yet sure what to expect from a mixed government that will include politicians ranging from Tea Party favorites like Kentucky Senator Rand Paul to unreconstructed liberals like California Senator Barbara Boxer.

Moreover, a big vote remains to be cast. This afternoon, the Federal Reserve will announce it’s plan for Quantitative Easing, Part Two. The central bank may promise to throw $500 billion or more at the U.S. economy to try and get it moving ahead more strongly. While considerable ink will get spilled on the elections, global investors are more focused today on the Fed.

In the markets, the dollar is mixed, a tad higher against the yen, little changed against the euro. Stock markets are marginally higher and Treasurys are showing modest strength. Cautious optimism prevails ahead of the U.S. open. Futures indicate a modest bump at the open.

Still, it would be a mistake to say markets won’t react to the election results. The Fed’s move is today. Those who won yesterday won’t take their seats until 2011. Once the Fed is out of the way, investors will start to decipher what the election results mean for the economy and the markets.

The Republican sweep to power in the House and the notching of a few more seats in the Senate changes the power dynamic in Washington. But it was not the epochal night that some forecast in the days leading up to the vote. Indeed, the result looks a lot like 1994 when Newt Gingrich and the Contract With America swept Republicans into power.

The Newt overbelieved his party’s achievements and bickered with President Clinton enough to shut down the government. He got the worse end of that deal and President Clinton sailed to re-election. It would be foolish for the Republicans to rewalk that path, at least in political terms.

But for all that, the post-1994 period was punctuated by strong economic growth and a booming stock market. But few expect such a replay. In 1994, the Fed tapped the breaks to keep the economy from overheating and then let it run after 1995. Today, the Fed is pulling out all the stops to get the economy moving, thus far without huge success.

With the economy in such ragged shape, especially compared with 1994-95, a replay of that gridlock era may not get cheered so loudly by the stock market. Instead, Wall Street will want to see the Obama Administration pivot to take a more friendly tone toward business and have the Republicans respond by delivering action that would turn a tonal change into policy reality that would spur economic growth.

A mixture of spending cuts, tax cuts, and, perhaps, some regulatory rollback in exchange for more firmly locking in the better bits of the Obama Health Care plan might be the combination that works best for Wall Street. Such an outcome seems a bit farfetched given the fractious mood in Washington, and that may be why the market is taking a wait-and-see approach.

Moreover, given the fiscal constraints, Washington will be hard-pressed to swing a $500 billion bat like the Fed is about to do. That is one more reason that tone as much as policy may influence how investors react to the new governmental mix.

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