The Politics of Delayed Disaster

NEW YORK ( TheStreet) -- It's hard to imagine how the market could agree so unanimously on anything other than "losing money is bad." But everywhere you look people are predicting imminent QE3 at this week's Federal Open Market Committee meeting, or at the very least in December. Even Chairman Mao got much more dissent, even at the height of the Cultural Revolution, than this view.

But why? And how?

The five-year inflation expectation has been on an uptrend ever since Operation Twist2. In fact, it passed above the significant 2% level last Friday.

Indeed, the nonfarm payroll number last Friday was bad, if you decide to focus on the bad part that is. And indeed it is an important data point for the Fed.

But if you take a step back and look at the bigger picture and over a slightly longer time horizon, the U.S. economy is decidedly, unequivocally, ho-hum. It's at least not bad (remember the 8/28 Case-Schilling housing data anyone?), which is the best thing any country can say nowadays.

To expand the Fed balance sheet when inflation expectation is 2%, the economy is mixed, and two months before an election would be unprecedented. It would create a huge risk of inflation and political hailstorm, thus badly damaging the Fed's credibility as well as the future of Ben Bernanke's personal career.

I guess it doesn't cost anything for the Fed to say "we'll maintain a zero interest rate policy indefinitely." Although they'll run out of short-term treasuries to sell by the end of Twist 2, I suppose they could redefine "short-term" and start selling longer-term holdings or even pull a twist on agencies.

But as Zerohedge pointed out, any significant increase in the Fed's purchase of long-term treasuries or mortgage-backed securities threatens overwhelming the market and exhausting liquidity.

In other words, the market has set itself up for certain and imminent disappointment, on a huge scale.

However, when things are so skewed, there must be some other rational explanation. The best rational explanation I've found so far comes from the always insightful John Dizard, by way of FT. It goes like this, in my words:

The Obama administration became worried in July that further worsening of the euro crisis would be very damaging to the re-election effort. Therefore they leaned heavily on eurozone leaders to at least hold it off until after the election. Particularly significant is German Chancellor Merkel's change of heart, over the very public and persistent objection from Bundesbank.

To summarize, it's all election politics. And I'll add Chinese politics into the mix: China will undergo its once-in-a-decade power transition in about a month. But the supposedly anointed next leader, XI Jinping, has been ubiquitously missing from several highly visible events in recent weeks, not the least being Secretary of State Hillary Clinton's visit. This coming right on the heels of the dramatic and embarrassing events around his former rival, Bo Xilai, rumors have spread far and wide about continuing power struggle and uncertainty in the transition. But now there are signs of this coming to an end.

How is this related to the economy and financial market? For the past month or two the Chinese government has been in a state of confusion and paralysis, on top of the general caution ahead of a power transition. Now the state machine is refocusing on avoiding economic crisis at any cost, from some concrete steps in implementing the new 1 trillion Yuan stimulus package to a massive organized stock buying -- not on direct government orders, but something like that, which institutional investors were more than happy to comply.

Combining both, the picture emerges: due to coincidence in timing, major governments in the world are highly motivated to delay disaster for at least a few months. In retrospect, U.S. markets have picked up on this and started taking position in mid-August. And it's likely that the reduction in uncertainty in Chinese politics will have visible and lasting (for a few weeks) impact worldwide.

Of course, just because governments try to delay disaster doesn't mean they'll succeed. Take the recently announced, already highly successful (before anyone knows what it will be) outright monetary transactions program from the European Central Bank as an example.

The market expects Spain and Italy to apply for rescue, which causes their yields to drop, which eliminates the need for rescue, which causes their yields to rise, which forces them to apply for rescue . . . This is a classic paradox illustrating the damage of government mucking around financial market. It forces bifurcation of outcome into two disparate, extreme scenarios.

In theory, there may be a rational way to price the outcome, the probability weighted risk premium. But it's an unstable state; the smallest perturbation would cause the system to rapidly coalesce into one of the two scenarios, rendering the prior pricing wrong. Unable to settle into a stable state, the market can only go schizophrenic, which is what I think will come out of eurozone over the next few months.

But it does constitute a reduction in short-term risk, which is all the market can afford to worry about.

To me, this seems a much more rational explanation of the market's behavior than the supposed QE3 expectation. It's risk-on all the way until year-end, baby -- long stocks ( SPY), gold ( GLD), short USD ( UUP), long commodities and commodity currencies, short volatility ( VXX). Chinese stocks ( FXI) seems a particularly compelling play since it's been beaten down relentlessly for months, and the risk would be perceived as much smaller provided the power transition does go smoothly.

That said, I will be watching FOMC meeting on Thursday very closely. The risk for disappointment is high. Going all the way in before then would be gambling. The market may be schizophrenic; I will try not to catch that bug.

At the time of publication, the author was long GLD and FXI.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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