- Equities hit new record highs as Democrats take full control of Congress
- But havoc on Capitol Hill keeps animal spirits in check
- Dollar kept alive by spike in real yields, gold not as fortunate
- Overall, Congress and Fed working together implies rosy outlook for riskier assets
Markets rally as stimulus hopes overpower social unrest
The Democratic party has officially taken full control of Congress after winning both Senate seats from Georgia, setting the stage for bigger spending packages to bolster economic growth. The news injected new life into the reflation trade, with US stock markets hitting fresh record highs and Treasury yields rising sharply as markets priced in bigger government deficits.
It will now be easier to unleash more spending if there is any hiccup in the recovery, so this paints a brighter outlook for the American economy. However, the tech sector had its reservations. The tech-heavy Nasdaq closed in the red, reflecting concerns about more taxation and regulation now that the Democrats have full control of the ship. The fear is that the broader economy is too fragile to sustain any tax hikes, but the tech sector isn’t, making it a juicy target for lawmakers.
But risk sentiment took a hit later after an angry mob of Trump supporters stormed Capitol Hill, decrying Joe Biden’s presidential election victory. While the shocking scenes caused a brief setback in stock markets, the retreat was minor. Investors don’t expect this to have a lasting impact on US politics or the economy.
Dollar hangs on by a thread, gold trampled
In the FX arena, the mood was calmer. The jump in real yields initially boosted the dollar, but those gains evaporated once the scenes of disarray on Capitol Hill took center stage. The question is whether this new era of huge deficits is going to keep the dollar in a downtrend, or whether investors will concentrate on the positive longer-term effects of bigger spending.
When a nation runs massive deficits, the main casualty is usually its currency. But coming out of a crisis, this may not necessarily be the case. If all the spending implies a shallower recession and stronger growth moving forward, that could negate deficit concerns, especially in the case of the US which prints the world’s reserve currency. Capital is ultimately attracted to growth, not the deflation brewing in Europe and Japan.
However, this is a longer-term story. For now, the market is focused on the reflation and deficit narrative, so the greenback may find it difficult to stage any lasting rally until the economic divergence between the US and other major regions becomes clearer.
In the commodity sphere, the main casualty was gold, which was trampled over by the spike in real yields. When yields rise, bullion becomes less attractive as it offers no yield itself. That said, the bigger outlook still seems favorable. The Fed will keep rates near zero for years, government deficits are about to balloon even further, and if inflation accelerates as the economy heals, that could push real rates even lower and light a fire under gold.
Both Washington and Fed to keep a floor under stocks?
Overall, the Democrats taking full control of government is great news for equities and other risk-linked assets. When the recovery hits a speed bump, Washington D.C. will likely ride to the rescue now alongside the Fed. And since the Democratic majority in the Senate is razor-thin, there is no real threat of significant tax increases. Until the Fed decides to close the liquidity taps, the ‘party’ could keep going.
Speaking of the Fed, the FOMC minutes did not contain any major policy signals and passed unnoticed amid all the mayhem yesterday. The ADP employment report showed a surprising loss in jobs, stoking concerns about the NFP print tomorrow.
As for today, the highlights will be the Eurozone’s preliminary inflation stats for December and the US ISM non-manufacturing PMI for the same month.
