The S&P 500 rose 12.8% in September and October — traditionally the two worst market months of the year. As I’ve been predicting since July, this rise is in anticipation of a major power shift in Congress. The market may celebrate even more if there is also a leadership shift in the Senate. All Wall Street wants is lower investment taxes, less onerous regulation, and more government gridlock – i.e., no big new spending bills for a year or two! The other big news this week will be some official word about the Fed’s quantitative easing (QE-2) targets at this week’s Federal Open Market Committee (FOMC) meeting.

Fed Infighting Escalates Over QE-2 Goals

Early last week, the U.S. dollar fell once again after Goldman Sachs issued a research report that said the Fed could buy up to $2 trillion in Treasury bonds, which would far exceed its previous round of quantitative easing (QE-1), which totaled around $1.25 trillion. The Fed’s “silence” regarding the target amount of new QE-2 liquidity has punished the U.S. dollar on world markets. My hunch is that the Fed is deeply divided on QE-2, with only a slim majority of the FOMC committed to more quantitative easing. Meanwhile, there is an outspoken minority (including the Fed presidents from Dallas, Kansas City, and Richmond) that will hold the line against QE-2, undermining Fed Chairman Ben Bernanke’s authority.

Bernanke is trying to be diplomatic about this rift, but he has been known as “helicopter Ben” ever since he said we should drop dollars out of helicopters if necessary. He clearly believes that the Fed should do whatever it takes to pump up money supply. Last week, for instance, he said that Japan did not do enough to fight deflation in the 1990s — a comment I find disturbing, since it reflects excessive fears of deflation.

The rest of the world is basically doing the opposite (becoming more austere, even raising rates), so they wonder, “What is wrong with America?” We seem to be literally abandoning the U.S. dollar to the currency wolves. To be fair, Fed Chairman Bernanke is not the only person undermining the U.S. dollar. For instance, he is not responsible for the federal government’s massive budget deficit, but his silence on the size of the Fed’s next round of quantitative easing has clearly undermined the value of the U.S. dollar.

TIPS: A Bold Plan to Balance the Budget!?

While I am talking about interest rates, a fascinating thing happened last week. The Treasury Department sold $10 billion of its 5-year Treasury Inflation Protected Securities (TIPS) at a negative yield for the first time, meaning that investors are betting that the Fed’s QE-2 campaign will be successful in reigniting future inflation. Specifically, these 5-year TIPS have a negative yield of 0.55%. I find it truly remarkable that investors would purposely accept a negative yield in exchange for future inflation protection!

In case you’re unfamiliar with these instruments, the holders of TIPS receive an adjustment to the principal value of their securities equal to the change in the consumer price index (CPI), in addition to a fixed rate of interest, which is naturally smaller than the interest paid to a holder of conventional debt. Frankly, with commodities soaring and the stock market back on a bullish track, I have no idea why investors would accept negative yields when looking for inflation protection. Buy gold and stocks instead.

Interestingly, the U.S. Treasury likes offering negative yields, so it has been signaling that it intends to increase the number of TIPS that it auctions. If the Treasury can continue to sell negative yields and if the CPI does not soar (since 40% of the CPI is tied to real estate, which is still soft), the Treasury Department may have figured out how to eliminate the U.S. government deficit! If the Treasury could auction over $13 trillion in new TIPS with negative yields … hmmm … we could eventually pay off the national debt!

Last Tuesday, the Case-Shiller home price index for August was reported as falling 0.2%, with home prices falling in 15 of the 20 metropolitan areas tracked. With an excess inventory of unsold homes and excess apartment vacancies, the Owners’ Equivalent Rent portion (40% weighting) of the CPI should guarantee that the CPI will remain fairly flat, giving the government a net profit on their current TIPS!

Stat of the Week: Consumer Sentiment Rising

Despite all the focus on the Fed and the elections, there was quite a lot of encouraging economic news released in the U.S. last week. If I had to choose one “stat of the week,” it would be rising consumer sentiment, as confirmed by two surveys: (1) On Tuesday, the Conference Board announced that consumer confidence rose in October to 50.2, up from a revised 48.6 in September and (2) on Thursday, the American Association of Individual Investors (AAII) announced that its survey of investor sentiment rose 1.6% to 51.2%, which is the most bullish investor sentiment the AAII has seen since May of 2008.

These confidence numbers were confirmed by some of the details of the third-quarter GDP flash estimate, which came out on Friday, when the Commerce Department announced that third-quarter GDP rose at a 2% annual pace. The best news in this flash GDP report was that much of the growth came from new inventories (adding 1.44% to GDP) and consumer spending (+0.9% to GDP). Since consumer spending accounts for approximately 70% of U.S. GDP growth, this came as a very welcome development.

The other good news is that on Wednesday the Commerce Department announced that durable goods orders rose 3.3% in September, due largely to a surge in civilian aircraft orders. Specifically, civilian aircraft orders surged 105% in September after declining 30% in August. Excluding civilian aircraft orders, durable goods fell 0.8% in September, but the overall headline will help boost third-quarter GDP.

Then, on Thursday, we learned that new jobless claims fell unexpectedly by 21,000 to 434,000 in the latest week. This brings the four-week moving average of claims down by 5,500 to 453,350. New jobless claims have declined three weeks in a row and are now at the lowest level since early July.

Overall, however, I’d say that the best economic news comes from overseas, particularly growth in Asia and Latin America. With worldwide GDP rising strongly, that will lift the earnings of the multinational companies that dominate the S&P. There are still plenty of third-quarter earnings announcements in the pipeline, so profits from overseas operations should continue to generate positive earnings surprises.