U.S. Heads Toward Fiscal Cliff Without any Brakes

By TJ Kim, Bondsquawk

The Fiscal Cliff scheduled by the end of 2012 has been a central issue, more pertaining to Wall Street than to Main Street. However, as the presidential debate will center on the topic of the Fiscal Cliff, U.S. voters will soon turn their attention to the gravity of the issue that involves a combination of spending cuts and tax increases to reduce the federal budget by as much as $501 billion.

Despite the urgency of the Fiscal Cliff, the politicians have not reached an agreement as to how to go about solving the government’s deficit problem, continuously delaying the progress while the economy is on the verge of tumbling back into a recession. Analysts from Royal Bank of Canada wrote,

“Unfortunately, politicians have not wanted to confront the issue in any sort of bi-partisan way and instead are playing a game of chicken with the U.S. economy by threatening to do nothing. This tactic will result in continued deterioration of consumer and corporate confidence which may translate to less spending and increased personal and corporate savings.”

If the current idle trend is to continue, we would have to allow the Fiscal Cliff to kick in without locating the underlying driver of the budget problem, the results do not look good.

“… the expiration of the “Bush tax cuts” will also occur, with the FC being enacted, with all income tax rates going up (the top rate going from 35% to 39.6%) as well as rates on estate and capital gains taxes. This would negatively impact the amount of disposable income that would be available to spend and thus impact growth.”

On the market side,

“UST yields could rise, U.S. funding costs would be negatively impacted and equity markets would underperform.”

As for the impact of the United States’ inability to address the Fiscal Cliff on the global setting,

“The macro impact on Europe would make the economic adjustment harder in the near term. As for the market impact on Europe – the blow to sentiment would be consequential. We would assume an immediate flight to safe and liquid assets, e.g. USTs. In addition, Euro based assets will look less attractive in an environment with very poor growth prospects. U.K. Gilts would certainly be an immediate beneficiary, as would smaller, safer and more insulated currencies (Norway, Sweden and Denmark). Finally, European periphery yields may take a hit and weaker growth will not make it any easier. Overall, this will probably force further monetary policy action and central banks may purchase more governmental debt.”

As mentioned before, Main Street will be more educated on the topic of the Fiscal Cliff as the Fiscal Cliff will the one of pressing issues to be discussed at the presidential debates. As a result, the market may react more dramatically in a negative way. Mainstream’s reaction to the Fiscal Cliff may drive consumption down with equity market, while sprouting a high possibility for the UST yield rising.

BondSquawk

BondSquawk is written by a team of bond market experts whose aim is to provide an unbiased view of one of the largest (but under reported asset classes in the world) – The world of bonds.

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