The tax compromise of New Year’s Day 2013 allowed the United States to avoid the worst case scenario of going over the proverbial fiscal cliff. Interestingly though, after the initial relief rally in equities runs its course, the longer-lasting impact may be to increase U.S. Treasury bond volatility and weaken the U.S. dollar.
The short-term case for heightened bond market volatility focuses on the debt ceiling. The tax compromise did not deal with the debt ceiling and only postponed the sequestration spending cuts for two months. Thus, we have another nail-biting game of political brinkmanship setup for the end of February and early March. While in the end, the politics of the tax compromise played-out with bi-partisan votes in both Houses of Congress, the take-away for market participants may be that a compromise on spending restraint allowing for a debt ceiling increase may be an even more bitterly fought battle and that a temporary government shutdown cannot be totally ruled out, although the probability is small.
The good news, in its own way, is that once the debt ceiling is raised, no matter how messy and disruptive the process, the U.S. economy will be clear to move forward. To be sure, there is austerity coming. The social security tax will rise and there will be more spending cuts of various forms. But this is hardly news for consumers and corporations and is outweighed by the improved ability to plan for the future. Our judgment is that the U.S. economy is well-positioned to overcome the drag from the coming fiscal austerity.
Also, we should not forget that we have two unrelated growth dividends on the way. First, the damage from Super-storm Sandy hit the economy in Q4 2012, while the rebuilding effort will be adding jobs and spending to the economy in the first half of 2013. Second, there is a long-term growth dividend coming to the U.S. economy from increased oil and natural gas production, and this could add 0.5 percent to 1.0 percent annually to real GDP over 2013-2020 depending on how fast infrastructure improvements are made.
This positive economic outlook will keep U.S. employment growing during 2013 and sets up the possibility that a gradually declining unemployment rate might dip below 7 percent before the end of the year. This potential incremental progress in reducing the unemployment rate is likely to put the Fed’s Quantitative Easing (QE) policy in market’s headlights during the second half of 2013. And, since markets embody a forward-looking discounting process, the likely casualty is the U.S. dollar, along with the Japanese yen, as the two currencies with central banks most committed to QE and highly accommodative policies well into the future regardless of their economy’s growth paths.