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Republicans Win the House, Weakening the President at a Time When Decisive Action May be Necessary

Fri, Nov 5, 11:11 AM ET, by ForexTraders.com

Today we have a lot of important developments. As the world prepares for the FOMC decision, and the U.S. evaluates the election results, we have the CDS and bonds of Euruzone periphery once again breaking new records. There is a chance that the focus will shift rather fast from the Fed to this region once the storm and turmoil of QE2 speculation calms a little, but to be sure we'll have to wait for today's decision. In the run up, gold was lower, USDJPY was higher, while the EURUSD showed little change.

China's exchange rate regime is bad for everyone, former Fms comment

Some speculation that the Monetary Authority of Hong Kong may drop the peg to the dollar at some point and adopt a Renminbi-based system is circulating among traders, but given the firmly stated viewpoint of the HKMA that the peg will remain in place for years to come, we are inclined dismiss the talk for now.

In perhaps more interesting comments, former head of the HKMA said that the internationalization of the Yuan should not require complete convertibility, suggesting that widespread use in cross-border financial transactions by domestic firms, and a Yuan-based trade regime between Chinese exporters and their overseas partners would be enough to establish the currency as an internationally acceptable transaction unit.

The point about internationalization without bconvertibility has always been our understanding of Chinese policy, and to see confirmed by a HK official with good relations with Beijing increases our confidence in the viewpoint that, in spite of all the talk, the Chinese do not envision a floating regime for the Yuan for a long time to come. That the currency must appreciate is accepted by the majority of Chinese authorities and academics, and internationalization of the currency is as much a strategic goal as it is an economic aim. But the Chinese would like to pursue their own course without making any commitment to yielding their power over the currency to the markets, since they are worried that doing so will expose the country to the volatile mood of the finance world, with very undesirable consequences for the one-party rule espoused by the CCP. In other words, they still have not abandoned the phantasy that it is possible to create a giant Singapore from the PRC, where the economy thrives under an authoritarian system through export profits, as the domestic system remains isolated from outside influences beyond the occasional cosmetic adjustment.

While controlling the pace of Yuan appreciation and managing a slow transition makes sense from the point of view of economic and political stability, the fact remains that China owes its prosperity entirely to free trade and free markets, and by opposing it at any measure, it is creating contradictions that can only be harmful in the long run. The huge changes that have occurred over the past three decades in communication technologies necessitate greater freedom, and cooperation between nations in shapes that cannot be defined or contained within the sterile framework of the nation-state. The apparent "them vs. us" mentality of the Chinese, seeking a safe zone free from the destabilizing effects of the West, reminds us of the isolation of the Ming era when it was thought possible that the nation would manage to prosper as long as it remained a coherent and strong whole, and turn a blind eye to foreign ideas. Yet these concepts are outdated and can only lead to a violent transformation towards greater liberalism, which we suspect, the Chinese authorities would go to any length in order to avoid.

Joseph Yam also criticized the irresponsibility of Americans as they depend on the reserve status of the USD to discard fiscal discipline, while expressing some disappointment at the Fed's almost total disregard of the external impact of its policies. While it is true that the Fed is acting in a chaotic fashion, we find it hard to find that exemplary central bank that gives a lot of consideration to the impact of its monetary policy decisions on the economies of its neighbors. Nonetheless, we should expect the Chinese to behave with greater discipline and credibility towards their partners than the Americans do, since, after all, the U.S. is a dominant power that is exploiting its power, while China is a nascent actor that is attempting usurp the dominance of the U.S. by acquiring greater prestige and respect on the international stage. In this context, the PBOC's irresponsibility in fixing the Yuan is hard to defend even from a self-benefit point of view. That it is being regarded as irresponsible was confirmed today in comments from the Asian Policy Forum meeting in the Philipines, where former officials of the Japanese and Thai finance ministries, among others, have called on the Chinese to understand that keeping the current exchange regime is not only bad for China, but for other Asian economies, too. Such splits among China's Asian partners certainly makes the job of the U.S. a lot easier as it seeks to "contain" China in the region.

The yuan was fixed at 6.6818 vs. 6.6925 yesterday against the USD.

Republicans gain the House, Democrats keep the Senate

In the mid-term elections, republicans have acquired the control of the House from Democrats, while the latter retain their majority in the Senate.

The early result of this is that President Obama, who is already regarded as being spent in terms of his power to pass new measures for boosting growth, will find his hands tied even tighter. On our part, we believe that he will not have a second term.

  • No Black Senators: Is it perhaps because the American public is surrendering to its racist instincts that none of the three African-American candidates was elected? With the only black senator retiring soon, the Senate will be an all-white body this term.

  • Extreme voices and fringe elements shunned: Sharron Angle, the anti-water fluoridation candidate, and Christine O'Donnell, the candidate with the foreclosed home, failed to get elected. Yet Ron Paul's son, Rand Paul was successful, giving the libertarian a voice in the upper chamber, and Marco Rubio, supported and endorsed by the former neo-con team of Vice President Cheney and George W. Bush, was also victorious.

According to a poll by CNN/Opinion Research Corp. Published on Monday:

"About 75 percent of Americans say things are going badly in the country The economy was rated the most important issue by 62 percent of voters, far eclipsing health care reform (19 percent), immigration (8 percent) and the war in Afghanistan (7 percent), according to the exit polling.

Most voters, 88 percent, rated economic conditions as not good or poor, and 86 percent said they were very worried or somewhat worried about the economy..."

Irish CDS, bonds break a new record on worries about a split over the budget

Meanwhile, in Europe CDS data provider Markit has been passing a stream of new records to newswires today, with the spreads reported at 538 bp after another rise of 15 bp today following the 27 bp widening on Tuesday. Irish government bonds were also yielding higher rates, with spreads over Germany's 10-year bund now being quoted 495 points at 7.398%. The Irish situation has deteriorated further after a member of the ruling Fianna Fail party, Jim McDaid resigned from his party, but the tone has been bearish on Irish debt since the weekend meeting of EU leaders, and it is not surprising to see the pressure being on in an environment of invisibility. There is some concern that the budget may not pass as the party's majority falls to just three.

Analysts were comforted slightly by the ability of Portugal to auction some Eur531 million 3-m and 500 million 12-m bills today at 1.818%( previous 1.96%), and 3.26% (previous 2.886% on October 20th). The interesting detail here is that while the yield on 3-month paper was lower by about 100 bp, the the 12-m bills were bought at a significantly higher interest rate, clearly demonstrating the uncertainty premium demanded by speculators/investors as we go further right on the yield curve. Overall the bid-to-cover ratio was 2.2 vs. the previous 2.4, which confirms that, while less bullish, yield hungry buyers are willing to finance the country provided that they receive acceptable returns on their investment. The summary is that the rising yield is a cause for concern, although we are not at the breaking point just now.

ECB is concerned with the deterioration in the CDS and cash markets over the past few weeks, and finally responded to today's tension by intervening in the 10-year bonds of Ireland and Greece. We may recall that the ECB's bond purchases had been on hold for a while, to which the vocal and almost intense opposition of Axel Weber is well-known. But the recent tensions are too strong to be dismissed, and the ECB is arguably stepping in to make sure that an unpleasant surprise doesn't overtake the reasonably calm interbank market.

Nations of the peripheral Eurozone are in dire straights. In Ireland unemployment rate has more than doubled this year to 13%+, in Spain it is very close to 20%, and expected to go higher, while in Greece it is up buy about a half to 12.5% this year, as the country tries to rebalance its budget in accordance with the PM's aggressive plan. One would expect the governments to ease and stimulate the domestic economies by engaging in fiscal spending, but with budget deficits of 14-15% in Ireland and Greece for this year, and around 11 percent for Spain for 2009, and a projected 9.3% for 2010, the focus is on austerity, as we know. As Joseph Stieglitz had complained incessantly during the 90s, imposing austerity while the economy is contracting frequently culminates in a default, and this simple fact, along with the extraordinarily large fiscal gaps of these small nations, lies behind the markets' pessimism about the feasibility of their recovery plans. Yesterday's PMI numbers which showed a 50 reading for these peripheral nations, while registering 56 for Germany, goes some way to illustrate the difficulties that the Euro will face as a consequence.

Against this background, we have the 3-month Euribor rising once again to 1.049% vs. 1.047%.

In Asia, shares closed mostly higher, with Shanghai the only loser as all the major bourses saw gains except Japan, where markets are closed today. U.S. Markets were fluctuating around the zero change level, no doubt awaiting the outcome of today's FOMC meeting. We will review the Fed's decision tomorrow, after the early storm settles.


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