Other Things More Important

FXSTREET asked me my opinion on the Midterm election and what it meant for the dollar.

I replied that Tariffs, Iran, ECB actions, and Fed actions were more important. So are Brexit and the budget confrontation in Italy.

The term "lame duck Congress" typically means the period between mid-term elections and when the new Congress is seated on January 6.

But if the Democrats take control of the House, which is very likely, little significant legislation will pass for the remaining two years of Trump's Term.

The open feud between Democrats and Republicans will stall nearly everything.

Congressional Makeup

I expect the Democrats will flip the house by a small margin and will do better than expected in the Senate. As of Oct 22, the Real Clear Politics base scenario is the Democrats lose 2 Senate seats. I think it is more likely the status quo holds or the Democrats lose just one seat. Democrats may even pick up a seat if Nevada goes their way.

I have Florida, Indiana, Missouri, Arizona, and Montana in the Democrat Senate column. If the Democrats win either the house or Senate, Congress becomes a two-year lame-duck session for fiscal policy.

There will not be another tax cut nor much of anything else.

What’s Priced In?

I suspect a Democrat flip is priced in, and accurately so. There may not be stomach for a second set of tax cuts anyway, unless there is a Senate blowout.

I suggest is not what Congress does that is meaningful, but rather what the ECB does, what Trump does with tariffs, what Trump does with Iran, and what the Fed does with interest rates that matters most. In a vacuum, Fed hikes are dollar-supportive. However, this isn’t a vacuum. Even if the Fed hikes, if they hike slower than expected, it would tend to weaken the dollar.

As of October 23, the market thinks there is a 78.8% chance of a hike in December with a 53.8% chance of another hike in March. If either of those do not happen, look for the dollar to weaken. Housing is faltering now. Homebuilders are getting clobbered. I suspect that March hike may not happen. Heck, the December hike my not happen.

But once again, this is looking at things in a vacuum. The Fed does not exist in a vacuum. One needs to consider other central bank actions, especially the ECB. The ECB is expected to taper in 2019. But what if they don’t? That would tend to weaken the Euro vs the dollar.

Tariffs Strongly in Play

More tariffs will definitely hurt the US economy and the global economy as well. Short-term, tariffs may cause a bit of price inflation and strengthen the dollar. Long-term, the Fed will resort to very unexpected rate cuts (at least as viewed from the present). If this plays out, the dollar may decline significantly.

Iran provides a similar setup. There is potential for a real short-term inflationary disaster if Trump sanctions work and oil from Iran is cutoff. There is also potential for the ECB, India, and other nations to ignore them. Oil fears may be overblown or not. I suspect they are, and look for oil to weaken.

Brexit and Italy Concerns

I failed to mention Brexit and Italy in my comments to FXSTREET. Both are very important. A hard Brexit runs a significant chance of a trade collapse between the UK and the rest of Europe. Contrary to popular belief, this will hurt the EU far more than the UK.

Why? Exports, fishing rights, and the UK's contribution to the EU budget. In contrast, the UK will be able to cut taxes, make trade deals, and escape ridiculous EU regulation.

Italy's budget rebellion comes at particularly difficult time for the Eurozone. Germany's exports will collapse if there is no Brexit deal, and that is increasingly likely.

Even if there is a deal, Germany is in a world of hurt over car emissions. And if Italy is cut to Junk (Moody's is one stop above junk level), its bonds cannot be used as collateral.

If on top of this, Trump puts a tariff on German cars, kiss Germany goodbye.

I doubt the Eurozone survives this onslaught intact.

For further discussion, please see Italy Openly Defiant of Eurozone Stability Pact, Deliberately and Knowingly

Guessing Game

The election question has everyone’s attention. But in reality, the other things I mentioned (Tariffs, Iran, Fed and ECB actions) are far more important than the midterms.

This was my FXSTREET conclusion:

We are all guessing at things here. Anyone who pretends otherwise is a charlatan. But as long as we are going to guess, let’s guess about the right things. Going out on a limb, my guess is Trump’s tariffs backfire spectacularly, a global recession hits in 2019, the Fed starts cutting rates, the dollar tanks, stocks dive, and gold soars.

Here's my article on FXSTREET: Tariffs, Iran, Fed and ECB Actions Far More Important Than the Midterms.

The above text also comments on the the meaning of lame duck while adding discussion of Brexit and Italy.

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Mike "Mish" Shedlock