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Tuesday Look Ahead: Markets Look to a Stingier Congress Post-Election

Tuesday's markets await the outcome of mid-term elections that are likely to bring a tighter fist to Congress, just as the Fed is ready to loosen its grip and wave on another round of easing.

Stocks Monday moved sharply higher, then lower, then higher, finishing barely changed on the day. The Dow was up 6 at 11,124 after moving in a 180-point range. The S&P 500 rose 1 to 1184, and the Nasdaq fell 2 to 2504. Stocks weakened in afternoon trading after ProPublica reported that theSecurities and Exchange Commission is investigating whether J.P. Morgan allowed a hedge fund to select assets for a credit deal backed by subprime mortgages.

The dollar gained fractionally. But it was a big driver of markets during the day as the euro reversed course, weakening on sovereign debt concerns. The dollar also strengthened on much better than expected ISM manufacturing data, which was at 56.9, well above economists' forecasts.

"A lot of the thought in the market is once the quantitative easing story moves off the table, and the market moves away from that, we may move back to the whole European sovereign debt theme," said Boris Schlossberg of GFT Forex. Credit default swaps for Greece and Ireland rose sharply Monday on renewed fiscal worries.

Election Tuesday

The Congressional mid-term election is expected to result in a Republican-controlled House of Representatives. Democrats are expected to retain control of the Senate though the gap in some races appears to be narrowing.

"I guess the real question now is how big is tomorrow. Once you get past 50 (new Republican) seats (in the House), does it really matter if it's a land slide number of seats? I think it'll matter," said Steve Massocca, managing director at Wedbush Securities.

"The better Republicans do, the better for the market. The worse Republicans do, the worse for the market. Interesting is going to be what Obama's reaction is to the election," he said. Markets have been pricing in gridlock in Congress, which is for now being viewed favorably.

The markets are also looking for a more fiscally minded Congress that will be more incline to limit government spending.

"You could say the tea party is responsible for QE2. It's not a coincidence that the locking down and vehement public rejection of further fiscal policy coincides with the Fed talking about helping with monetary policy," said Kevin Ferry of Cronus Futures Management.

The week's second big event — the Fed's two-day meeting — starts Tuesday and ends with a much-anticipated statement at 2:15 p.m. Wednesday.

Many economists expect the Fed to announce an open-ended plan to purchase Treasury securities at the rate of about $100 billion per month.

"I think we know what expectations are in terms of the things to happen. We know what the expectations are but what I don't know is what the expected reaction will be. That's difficult to predict," said Massocca.

Goldman Sachs economist Andrew Tilton said the Fed could announce either a total amount or a monthly rate of Treasury purchases, when it issues its statement Wednesday. "We think the initial announcement will be $500 billion by some time in the spring of 2011," he said.

Barclay's Capital chief U.S. economist Dean Maki said he thinks the Fed is going to leave the program open-ended. "It is a little hard to see how they stop soon, given they are far enough from their mandates. Even a year from now, we think growth and inflation will not be close to their mandates," he said, adding he expects purchases of $100 billion a month.

In theory, quantitative easing should push lending rates lower in an environment where the Fed has already put its target Fed Funds rate at zero. The easing would also reflate assets and add money to the system. Since the Fed started talking about a new easing program, the dollar has slumped and stocks have risen about 12 percent. Commodities prices have also moved higher. The yield on the 10-year Treasury, at 2.625 Monday, is about where it was when Fed Chairman Ben Bernanke first discussed easing in Jackson Hole, Wyo. at the end of August.

What's Next?

Analysts and economists are focused on what happens after the election, when the lame duck Congress is expected to take on the Bush tax cuts.

Economists say the tax cuts are a factor in their 2011 GDP calculations. Maki expects GDP at 3 percent in the fourth quarter, but 2.5 percent in the first quarter of 2011. "We do have a bit of slowing into Q1 because we're assuming the upper income tax cuts are allowed to expire. That's the Obama plan and that's looking less likely now that the Democrats didn't take a vote before the election," he said.

Maki said if the tax cuts expire and stay expired next year, he expects GDP of 2 percent for 2011. "If they are all extended, we would say growth would stay closer to 3 percent," he said.

"This actually matters. It's a little unnerving that we're in November and we don't know what the tax policy is going to look like..It is important that the lame duck session of Congress makes a decision because it would be disruptive otherwise," he said.

Morgan Stanley chief U.S. economist Richard Berner said expiration of the tax cuts would result in a $175 billion fiscal drag in 2011. That together with the offsetting boost from Fed easing would result in a hit of about 3/4 of a point to GDP. "If it weren't for that offset, it would be a lot bigger. It's a big fiscal drag," he said.

There has been some talk that Republicans prefer to tackle the issue in January. Analysts say if that happened, the Treasury would have to get involved since if the tax cuts expire, employers would normally be mandated to withhold at a higher level starting Jan. 1.

Earnings Central

Dozens of major companies report earnings Tuesday. They include BP, ADM,Pfizer,Kellogg, MasterCard, Newmont Mining,Marathon Oil, Medco, Tevaand Amerisource Bergenahead of the opening bell.Discovery Communications, Electronic Arts,Hertz and Hartford Financial report after the market close.

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Questions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.