This hasn’t exactly been a warm week for China. From territorial disputes with Japan, growing uncertainty about North Korea’s changing of the guard, and continued pressure by the U.S. and Europe about its undervalued currency – China has responded rather coldly – it simply refuses to be told what to do. A tit for tat protectionist tussle between the U.S. and China ensued over the past month, and last Thursday, China’s premier re-emphasized China’s tough stance on the renminbi. These developments caused the dollar to sell off hard and gold to rally, and spooked the equity markets. Until Friday morning when a decent enough durable orders report supposedly triggered a wave of buying. The durable goods report was not stellar by any means – it was actually down -1.3%. No, there must have been other reasons for the huge gap up on Friday’s open. All one can say is that equity traders’ view of the world had radically changed from Thursday afternoon to Friday morning.
The question now is whether equity markets will move higher based on this overnight change of sentiment. Do Bernanke’s comments last week reemphasizing the need for quantitative easing (QE) have anything to do with it? Last week’s FOMC statement read “inflation is likely to remain subdued for some time before rising to levels the committee considers consistent with its mandate.” In effect, Bernanke made it perfectly clear that he felt that there were no inflationary pressures in sight. This means that the Fed will continue to add liquidity to the economy whenever necessary. That takes care of the monetary side of the macroeconomic puzzle.
As for the fiscal side? Well, there is no sign that either the GOP or the democrats want to iron out the debate on the Bush tax cuts before the elections in November. This uncertainty will keep downward pressure on the dollar as well as on Treasuries, barring any talk of fiscal restraint by the administration. Added uncertainty comes from Larry Summers’ departure from the economic advisory team. Will Summers’ replacement be someone with more of a populist message? This uncertainty will also add to pressures on the greenback and on treasury bonds. With this backdrop one can understand why the Chinese are not pleased about demands to let the renminbi appreciate. With over $868 billion in Treasury bond holdings, China certainly wants the dollar to remain stable and the U.S. to show more fiscal restraint. That’s slightly less than $3,000 that every American owes the Chinese government. On the one hand, China would not mind aligning with the Tea Party rhetoric of keeping the size of government small – but they would not agree with the Tea Party’s means of getting there – by lowering taxes. This would jeopardize America’s ability to balance its budget and create a crisis of confidence as far as our creditworthiness is concerned.
All this uncertainty keeps a lid on the equity markets. There may be a few more days of follow-through binge buying for the equity markets, but then reality will once again set in – reality in the form of Q3 earnings reports in October and further economic statistics – with particular focus on jobs reports. Then we have the pre-electoral phase. It is expected that the democrats will lose a few seats in both houses of Congress. From the perspective of the Treasury market, a little GOP pickup wouldn’t hurt – because it will mean that the administration will have less power to implement fiscal stimulus policies. This development would also keep a lid on the rally in the stock market. But let’s not forget the floor that Bernanke has built to support the financial markets – and the Fed is quite a force to be reckoned with.