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Look for the Dollar to Recover: Opinion

By Marc Chandler

The outcome of the U.S. mid-term elections and Federal Reserve Open Market Committee meeting, coupled with the various economic reports, strengthens our base case scenario in which we expect the U.S. dollar to generally trade higher as the 2010 winds down.

Many expect the dollar to decline in the wake of the $600 billion Treasury buying program of the Federal Reserve. In contrast, we emphasize the anticipatory nature of investors. The dollar's relentless decline in September and October was, in fact, the market pricing in QE2.

As it became clear the Federal Reserve was going to provide more monetary stimulus, we anticipated roughly a 10% decline in the dollar that would carry the euro toward $1.40 and sterling toward $1.60. At the same time, we suspected that the dollar would not gain much traction until uncertainty around U.S. fiscal and monetary policy would be lifted by the outcome of the U.S. election and the FOMC meeting.

Election

In the most immediate sense, the significance of the election is that it will allow for the resolution of key issues for businesses and households: marginal tax rate in 2011. At the same time, the Republican victory increases the odds that the 2001 and 2003 so-called Bush tax cuts get wholly extended. And finally, there appears to be a reasonably good chance that the unemployment benefits program that is set to expire at the end of this month are extended as well.

However, it is important to keep in mind that these measures will only temper and not reverse the fiscal headwinds the U.S. economy faces in the coming quarters. At this point there seems little political appetite of renewing the payroll tax credit (Making Work Pay), the single biggest program in last year's stimulus program. Indeed, the impact of this could be most severe in the start of 2011.

It is difficult for nonpartisans to divine a clear message from the Republican victory. Exit polls suggest that less than 1 in 5 thought health care was a top issue and voters appeared split (48% to 47%) between favoring repeal of national health care and expanding it. A little less than 40% thought reducing the deficit was the top priority, while a statistically identical 37% wanted to spend more money to create jobs, a full third of whom identified as Republicans. If it is clear what was voted against, it is not clear what was voted for.

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