The reflation trade that’s been bubbling since late-August has had a good run, and it’s helped tip the outlook from negative to slightly positive. But the trend faces new challenges. The revival in expectations about the economy in recent months is still poised to prevail, and that’s no small plus to help mend the macro ills. But there’s a new batch of turbulence in town, and much of it is blowing from political debates. Even if everything was peachy keen with the pols (and it most certainly is not), the improved outlook for the U.S. economy in recent months remains a precarious renewal. Add in the new turmoil in Washington into the mix and the waning days of 2010 are likely to bring a fresh round of volatility to the capital and commodity markets.

On the plus side, expectations about the Federal Reserve’s latest bit of monetary stimulus—dubbed QE2—have buoyed the crowd’s sentiment since September. Stock prices are substantially higher from two months ago and the Fed’s formal announcement of QE2’s details last week are set to replace expectations with action. The New York Fed today will begin purchasing as much as $8 billion of Treasuries, and the buying could total $100 billion-plus by early next month.
Accompanying the Fed’s latest efforts to stabilize falling inflation expectations and provide additional juice to the economy is marginally improved news on the jobs front. On Wednesday the Labor Department reported that weekly initial jobless claims fell to 435,000 for the week through November 6, the lowest since July. Meanwhile, last week’s positive surprise for growth in October’s payrolls is another down payment on keeping hope alive.
But the economy faces new potential setbacks to sentiment, and perhaps the real economy, as the year winds down. The uncertainty over the Bush tax cuts is one factor. There’s also a dust-up over reports about the indecision that dominated the Group of 20 meeting in Seoul over the last few days on matters of so-called global imbalances. A third issue is the re-energized debate about U.S. fiscal policy and the government’s debt load in the wake of details released from President Obama’s bipartisan debt-reduction commission
There’s a sea of discussion about what it all means, and which path is prudent vs. reckless. The biggest issue at the moment, however, is the uncertainty that accompanies these hefty subjects.
The situation, however, is fluid. The uncertainty over the Bush tax cuts, for instance, may be giving way to resolution. “President Barack Obama’s top adviser suggested to The Huffington Post late Wednesday that the administration is ready to accept an across-the-board, temporary continuation of steep Bush-era tax cuts, including those for the wealthiest taxpayers,” The Huffington Post reported earlier this week.
But there are no free lunches. Extending the tax cuts would come at a steep price for expected government revenue. According to CBS News:

The tax cuts enacted in the early years of the Bush administration are set to expire at the end of the year if Congress does not act. President Obama has urged Congress to extend the tax cuts for all Americans, except for the top 2 percent of income earners. Letting the tax cuts lapse for the top 2 percent would save the government $700 billion over the next 10 years, the president has repeatedly argued.

However, Republicans are interested in extending all of the tax cuts, and after significant gains in the midterm elections, they are signaling they are not interested in compromising.

Damned if you do, damned if you don’t. The case for extending the tax cuts, at least temporarily, has merit, given the weak and still-vulnerable economic recovery in the U.S. But left-of-center politicians and economists are fighting back on what appears to be the White House’s new willingness to let Republicans have their way. Yesterday, “liberal groups made clear that if the president were going to agree to extending tax cuts for the wealthy—even temporarily—Democrats should demand concessions on other matters, such as extending unemployment benefits, according to two people familiar with the meeting,” The Wall Street Journal reports.
But just when it looked like the White House had thrown in the towel and conceded to Republican demands to extent the tax cuts, senior White House adviser David Axelrod said that the negotiating process was still very much alive and kicking. “We’re willing to discuss how we move forward,” Axelrod explained to the National Journal yesterday. “But we believe that it’s imperative to extend the tax cuts for the middle class, and don’t believe we can afford a permanent extension of tax cuts for the wealthy.”
Tax cuts, it seems, are still in play and remain a work in progress. There’ not much more clarity on the global front as it relates to the latest G20 meeting and how (or if) the world’s biggest nations will address trade imbalances. As Reuters reports today:

G20 leaders closed ranks on Friday and agreed to a watered-down commitment to watch out for dangerous imbalances, yet offered investors little proof that the world was any safer from economic catastrophe.

After an acrimonious start, the developing and emerging nations agreed at a summit in Seoul to set vague “indicative guidelines” for measuring imbalances between their multi-speed economies but, calling a timeout to let tempers cool, left the details to be discussed in the first half of next year.

“It’s fair to say we didn’t resolve those issues here,” the Canadian prime minister, Stephen Harper, tells The New York Times. “These are not going to be easy issues to resolve but I think we’ve got everyone talking the same language, everyone understanding longer term what has to be done.”
The outlook is hardly any clearer with the Obama’s debt-reduction commission. If anything, news of the commission’s plans have only achieved more debate about how to pare the country’s red ink. “On Wednesday, the co-chairmen of Obama’s debt commission, unable to forge consensus among the deadlocked commissioners, came out with their own version of a plan to conquer the deficit, reduce the debt, overhaul the tax code and put entitlement programs on solid ground. It was quickly pronounced dead on arrival by no-regrets Pelosi, who called it ‘simply unacceptable,'” writes the Washington Post columnist Dana Milbank. “Is this how the next two years will look?” he asks. Probably, he opines.
The markets hate uncertainty, according to the old saying. Well, there’s a fresh batch of uncertainty these days, and in quantities that are more than trivial. This time the offending variable is political. In any case, the stakes are high and the outlook is fuzzy…again. Back to the future.
Yes, this too shall pass. In fact, the period ahead may be favorable for savvy investors willing and able to tolerate volatility. But earning an enhanced risk premium won’t come easy. That, at least, is one thing you can count on, no matter what they say or do in Washington.