Will Focus Shift to Europe?

With the FOMC looming, the market essentially yawned at the US election results, which gave the Republicans control of the House of Representatives by margin that looks to be at the high end of expectations. The GOP appear to have stopped shy of taking the Senate. An extension of the 2001 and 2003 tax cuts look increasingly likely. The China bill may less likely to go through the Senate now. Yes the bill had bipartisan support in the House, but the Republicans in the Senate may not want to support an Democratic initiative they don't have to and plan for their own initiative next year.

A stronger than expected UK service sector PMI underscored the point, driven home with last week's stronger Q3 GDP figure that the BOE is in no position to follow the Fed in QEII this week. With BRC shop prices (9 month high) and CPI elevated (though set to decline on base effects), it must be off the table for several months at least.

Since it became clear the Fed was going to engage in another round of asset purchases, I had expected the dollar to suffer as the market priced it in. I argued that the uncertainty surrounding next year’s marginal tax rates and the FOMC decision would be lifted here in early November. After this uncertainty is lifted, I expected the markets to shift the focus toward the certainty in Europe. That certainty is that the combination of tightening fiscal policies around the corner, coupled with rising short-term interest rates, less liquidity and a stronger euro will act as a significant headwind on business and consumers. At the same time, we expected the still unresolved debt dynamic issues, under relatively weak political leadership to cause the unresolved debt dynamics to resurface.

The European decision at the end of last week to endorse the German call for a permanent debt crisis mechanism with the emphasis on private sector participation has weighed on the only weak peripheral bond markets in Europe. Irish bonds, for example, are lower for the 8th consecutive session today and the premium against Germany has doubled in the past 3-months. With today’s decline, the Greek 10-year bond’s losing streak is the longest since April. ECB President Trichet has expressed concern that the German initiative cut undermine peripheral bond markets as it essentially warns investors that after 2013 that debt restructuring will replace tax payer bailouts. German Chancellor Merkel acknowledged that she disagrees with Trichet on the level of risk. This could be an interesting line of questioning at Trichet’s press conference tomorrow.