John Taylor, who has not made any friends at the administration with his recent comparison of Ben Bernanke to Hitler, has released his latest letter whose purpose is to disabuse what Traxis flip flopper extraordinaire Barton Biggs (or rather is praying, due to his high single digit negative YTD P&L), as well as many others believe, will be a 10% boom in stocks prices following November 3. Wrong. As this whole rally has been liquidity driven, all that will take to reverse it, is for someone to step between the Chairman and his favorite Hewlett Packard. That someone: anti-Fed crusader Ron Paul, who will see this as his last mandate (and chance) to leave a memorable mark on the Fed's modus operandi: "After the Republican victory things will change. The Fed will be hamstrung, as Ron Paul, a conservative standard-bearer and harsh critic of the Fed, will head the sub-committee overseeing its actions. Liquidity expansion or new programs will probably drop sharply under his watch. Paul would argue that the Fed’s unfettered ability to “debase” the currency is about to come to an end" Which is why all those who believe "more of the same" will continue indefinitely, may be wise to hedge their bets. Taylor also looks at the game theory between the Fed and the ECB: "As the US authorities turn to a tighter monetary and fiscal policy, driving the country into a recession, causing the US and its banking system to withdraw liquidity forcing the dollar higher, the ECB will be forced to be more accommodative. Our analysis argues that the month of November will see the flash point that begins to reverse the markets’ optimistic course."

A Major Risk Reversal Is Coming Soon

October 28, 2010

By John R. Taylor, Jr.

Chief Investment Officer

Two important elections occur during this next month, one in Greece and one in the US. In both we should see a swing to the right and this move, if large enough, could just be the event that kicks off the next global recession. Although the newswires have hardly mentioned Greece during the past four months, the situation in Athens remains difficult. Even though most of the drastic measures have yet to be implemented the PASOK government is being roasted in the opinion polls, where 67% say that it is doing a bad job. Municipal elections occur in two weeks and it seems clear that the Socialists will lose in all parts of the country, defeated both by the right and in some cases by splinter groups of all types.

Although one could pass this off as nothing more than an unimportant popularity contest, Prime Minister Papandreou stated this week, ”the citizens will give a clear signal where they want the country to go.” If his party loses this support, he would call a general election as a referendum on the “Memorandum” with the EU, ECB, and IMF. Despite what the opposition calls his “blackmail,” the PASOK will lose next weekend and the Greek crisis will pop onto our radar again. If Papandreou does call a general election, the risks will be enormous as the entire program will be placed under the looking glass once again – and the government will probably be defeated at the conclusion of the debate.

Across the ocean, the American mid-term elections will not unseat Obama, but will further limit his very limited freedom of action. The House of Representatives should be comfortably controlled by the Republicans while the Senate should be split within one or two votes of 50–50. In the US this means certain gridlock at a time when fiscal tightening is already programmed into the next few years. If any fiscal stimulus is applied, it will be through tax relief rather than through targeted government programs. The euro has been strong and dollar has been weak for the past two months, but these two elections should have a big impact, most likely reversing these trends. Currently, the US Fed has anticipated the economic slowdown resulting from the withdrawal of the fiscal stimulus by trumpeting its new round of quantitative easing. The expectation of this dollar-creating process is resulting in a very weak dollar.

After the Republican victory things will change. The Fed will be hamstrung, as Ron Paul, a conservative standard-bearer and harsh critic of the Fed, will head the sub-committee overseeing its actions. Liquidity expansion or new programs will probably drop sharply under his watch. Paul would argue that the Fed’s unfettered ability to “debase” the currency is about to come to an end. The leading indicators call for a US recession next year – and Bernanke is acting as though he believes this – but with the Republican dominance, fiscal and monetary support will not be quickly supplied, which implies a stronger dollar. Fiscal stimulus is being withdrawn dramatically in Europe and the Eurozone is on its ways to a recession as well. Although the mean GDP for the Eurozone has been impressive lately, arguing that Europe is doing well is like arguing that Dallas, Texas has a balmy Mediterranean climate as the yearly mean temperature is 19oC, but in the summer the mean high is 36oC and in the winter the low is 2oC. The average obscures a lot if information and never more so than in Europe: Germany is in the summer while Ireland and the other PIIGS, roughly 30% of the populace, are in the winter. Although the Euro-authorities will be reluctant to act until a crisis rattles them, Greece could do it again. As the fiscal austerity begins to bite, the ECB will eventually be forced to further inject liquidity into the banking systems and support them too. As the US authorities turn to a tighter monetary and fiscal policy, driving the country into a recession, causing the US and its banking system to withdraw liquidity forcing the dollar higher, the ECB will be forced to be more accommodative. Our analysis argues that the month of November will see the flash point that begins to reverse the markets’ optimistic course.

Also, here is Taylor's recent, and just slightly less pessimistic interview with Erik Schatzker.