Markets could have volatile reaction to fiscal deal

Markets could have volatile reaction to fiscal deal

Wall Street is finding it difficult to price the likely impact of a “fiscal cliff” deal on the economy, raising the possibility of a wild swing in the market if and when a deal is announced.

So far, the markets have largely kept an even keel during the “fiscal cliff” negotiations, reflecting optimism among traders that congressional leaders will not let the recession-inducing policies of the “cliff” take effect.

But analysts in New York say the markets could shift violently once the outlines of an agreement come into focus.

“The debt ceiling — you were either going to default or not,” Michael Feroli, JPMorgan’s chief U.S. economist, told The Hill. “Here there’s a whole range of outcomes.”

While the debate over the fiscal cliff bears some similarities to the debt-ceiling standoff of 2011 — both featured dueling press conferences, closed-door meetings, and plenty of brinkmanship — it also poses a different challenge for the financial world.

For Wall Street, the debt ceiling debate was fairly cut-and-dry: So long as Washington avoided default on the nation’s debts, the economy was safe.

The fiscal cliff debate is more complicated because it covers a broad range of tax and spending provisions, each with the potential to take a major bite out of the economy if left unresolved.

Analysts at the Congressional Budget Office (CBO) have warned that letting all the policies of the fiscal cliff take effect would create a recession. An end-of-year agreement might not reverse all of those policies, however, making the impact on the economy hard to predict in advance — much to the dismay of traders who are paid to do just that.

One of the biggest unknowns is what the nation’s tax policy will look like in 2013.

President Obama has placed raising tax rates on family income above $250,000 a year front-and-center as he pushes for a cliff deal, a proposal that House Republicans have declared a non-starter.

But the rates on individual income aren’t the only unresolved tax issues of the fiscal cliff.

Lawmakers are also grappling with a possible extension of the payroll tax cut and the Alternative Minimum Tax — the patch for which actually expired at the end of last year. Those provisions, while not garnering many headlines, carry an economic wallop all of their own.

“All the debate is mostly about the income taxes and potential spending cuts, but there’s this whole panoply of other items that have to get cleared up,” said Kevin Logan, chief U.S. economist at HSBC.

Wall Street economists have taken a particular interest in the two-percentage point cut in the payroll tax cut, which has been in place for two years and is scheduled to expire on Dec. 31.

Obama proposed a third year of the tax cut as part of a fiscal cliff offer this month, but Republicans have opposed an extension, calling it an ineffective form of stimulus.

“I was hopeful that was a tax rate reduction that might increase jobs. It did not, except maybe peripherally,” Sen. Orrin Hatch (Utah), the top Republican on the Finance Committee told reporters this week. “And so I’ve lost real interest in that.”

While some Democrats are pushing for an extension of the payroll cut, others are concerned about its impact on Social Security, which receives revenues from the tax.

According to the CBO, an increase in the payroll tax rate, coupled with the expiration of extended unemployment benefits, would shave off 0.7 percent from the nation’s economic growth.

Wall Street analysts tracking the debate in Washington have been preparing to bid adieu to the tax cut, and are contemplating the economic drag that will likely result.

“If it weren’t for this payroll tax increase, we’d be looking at a somewhat stronger economic performance,” said Logan.

But despite the uncertainty about what Congress might do, markets have stayed relatively calm in December. Logan thinks investors learned from last year’s fight over the debt limit.

“Back in 2011, people panicked a bit,” he said. “There was a lot of risk and people were quite concerned. But in the end it got worked out, they didn’t crash the economy. Many investors now are taking an approach of we’ll get through this, and when we do we should still be invested in the stock market.”

But that sanguine outlook may miss some of the complexity in the latest round of fiscal chicken. The expiring payroll tax cut is just one piece of a slew of expiring tax provisions. Coupled with the wide range of possible deals that could emerge, markets have more outcomes to consider than they did during the debt limit fight.

Feroli said market players might be oversimplifying the debate to a basic binary: a deal is good, and the lack of one is bad, regardless of the contents.

“I get the sense that most people feel, if you get a deal, that would be good — even if it doesn’t extend payroll. I kind of think they may be underestimating just how much support this economy is getting from the payroll tax cut,” Feroli said. “I think the lesson they’re taking from last year is that anything called a deal is good.”

From Logan’s perspective, the difference between the fiscal cliff and the debt limit fight comes down to the devil you know versus the one you don’t. With the debt limit, investors had no idea what would happen if the U.S. defaulted on its debts, because it has never happened.

“Nobody could even contemplate what would happen,” he said. “The best thing to do was just get out of the way.”

With the fiscal cliff, markets at least have a broad sense of the impact of the two broad outcomes of the cliff standoff — deal or no deal — and can respond accordingly.

“Tax increases or spending cuts, while they may be onerous to the economy, they don’t happen at once, they take place over the course of the year, and people know what they are,” Logan said. “You can more or less anticipate what the effects will be.”

Source: The Hill