Dollar could slide if Congress goes to Democrats
Fri Oct 20, 2006 1:33 PM ET
By Steven C. Johnson
NEW YORK (Reuters) - Long considered a truism, the idea that "political gridlock is good for financial markets" may prove false for the U.S. dollar after the Congressional elections next month.
Recent opinion polls show the Democratic party has a good chance of winning control of Congress in the November 7th elections, increasing the risk of dollar-negative reforms.
Some investors fear that a fiercely adversarial Congress that confronts a Republican White House on Iraq, taxes, spending, and free trade, could cause enough policy uncertainty to frighten foreign investors into cutting back temporarily on buying dollar-denominated assets.
"It would create problems for the stock market and maybe make some foreigners wary of financing the U.S. deficit, leaving the dollar vulnerable," said Michael Cheah, who manages $2 billion in mostly fixed-income investments at AIG SunAmerica Asset Management in Jersey City, New Jersey.
With less than three weeks to go until the election, polls show support for the ruling Republicans and President George W. Bush at levels that are worse than when the Democrats lost control of Congress in 1994.
Currency strategists worry that Democratic vows to repeal President George W. Bush's capital gains and dividend tax cuts could hurt the dollar, as could renewed attempts to slap tariffs on Chinese imports.
Andrew Busch, global market strategist at BMO Capital Markets in Chicago, said rescinding tax cuts would end the stock market's recent bull run, adding "the dollar wouldn't get any traction from that."
HEADING FOR GRIDLOCK?
Forecasting the impact of elections on any financial market is a delicate art, and that's especially so given the dollar's idiosyncratic behavior this year.
The dollar has shed some 7.0 percent versus the euro since January, but has not fulfilled the dire forecasts of those who expected a slower economy, a narrowing interest rate advantage over Europe, and an ever-widening U.S. trade deficit, to combine to spark a dollar freefall.
Polls show Democrats have a strong chance of winning the House of Representatives, the legislature's lower chamber. Should they capture the Senate, too, President Bush's agenda could be stuck in neutral during his final two years in office.
Unlike most voters, financial markets tend to view gridlock as good, reasoning as political humorist P.J. O'Rourke once famously did, that "giving money and power to government is like giving whiskey and car keys to teenage boys."
Dennis Gartman, independent analyst and author of the daily Gartman Letter on investment strategy, concurred. "I am a firm believer that the best form of government is gridlock," he said, adding that fewer new laws usually mean less interference in markets.
In a recent note to clients, Deutsche Bank strategists pointed out that the dollar rallied in 1981 and 1995 following midterm elections in which single-party control of Congress and the White House gave way to shared control of government.
While the high level of U.S. interest rates at those times undoubtedly played a role, "the U.S. political mix at the very least did not appear to provide an impediment to the dollar," they wrote.
BRIGHT SPOTS
But Deutsche Bank's Frank Kelly, who keeps an eye on government affairs of interest to investors, said strong opposition to President Bush's policies may make the Democrats' post-election agenda quite activist in order to generate momentum for the 2008 presidential election.
Also, BMO Capital Markets' Busch notes that he who controls the House wields "enormous power" because passing legislation requires a simple majority, unlike in the Senate, where a party must marshal 60 of 100 votes to push bills through.
There are potential bright spots for the dollar though. Some feel that Democrats would be more committed to a balanced government budget, which in the long run could be beneficial for the dollar.
The U.S. also runs a current account deficit with the rest of the world of around 6.0 percent of gross domestic product and relies heavily on foreign buying of U.S. assets to finance it.
Some economists fear that if the Federal Reserve cuts interest rates next year amid slower U.S. growth, investors could shy away from U.S. dollars, making it harder for the country to finance its trade deficit.
But AIG's Cheah said it would take a Democrat in the White House, as well as running Congress, to make progress on this front.
Meanwhile, protectionist pressures will mount irrespective of who controls Congress, if the U.S. economy continues to slow in 2007, said Brad Setser, research director at New York consulting firm Roubini Global Economics.
But Cheah said the sheer volume of pressing issues facing the White House these days, from Iraq and Afghanistan to Iran and North Korea, mean two years of bickering and uncertainty would unnerve markets.
"We have a lot of such problems, and investors are concerned about them," he said.
AI
