A week before Thanksgiving, markets weakened as the fiscal cliff draws near. Spreads widened and the S&P 500 fell to its lowest levels since July.
Now that the election is behind us, the focus is back on the fiscal cliff. The markets are trying to figure out how to price the risk of the potential of over $600 billion in tax increases and spending cuts due in 2013. In a roughly $15 trillion dollar U.S. economy, this equates to about 4% of gross domestic product (GDP). Last quarter the U.S. GDP grew at a rate of 2%, so under a worst-case scenario this cliff is more than enough to push us back into a recession. The recent history of budget deals offers little hope that an agreement to forestall this fiscal restraint will come quickly or easily, but there is still much to suggest that the cliff, at least in large part, will be avoided. The most likely scenario is a short-term deal at the last minute, with a total impact of roughly 1.5% in fiscal drag from a combination of spending cuts and tax provisions. Those are likely to come in the form of discretionary spending caps, health-care law taxes and the expiration of payroll tax cuts.
The 10-year Treasury yield ended the week at 1.58%, near an all-time low and well below the nearly 2.40% inflation rate that the TIPS market is pricing in over the next decade. This means that investors have maintained such faith in the U.S. government that they are willing to lend it money over the long-term without any demand of a real return. Further, the financial repression is likely to continue for some time to come, in other words, the Fed's monetary policy of extremely low rates will continue to hurt savers and encourage spenders in a an effort to reflate the economy. The real question is when are we going to stop kicking the can down the road? The can is getting bigger and the road is leading into a narrower alley.
It is worth noting that despite all the headwinds the economy is facing, we are seeing encouraging signs in the state of the labor and housing markets, coupled with improving consumer confidence and auto sales, but this is no way negates the danger of the fiscal cliff.