The Fiscal Cliff.

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What is the Fiscal Cliff?

The fiscal cliff is the name given to the series of tax rises and spending cuts that the USA face on the midnight of 31st December 2012. The reason it is known as the ‘Cliff’ is that the changes in taxes and spending will come into immediate effect as of January 1st 2013. The temporary payroll tax cuts from last year will come to an end and result in a 2% increase of tax for workers and in addition some of the spending cuts agreed to avoid the debt ceiling in 2011 will come into effect. These are just two examples of a multitude of changes due to occur in the American fiscal system, some of which date back to the Bush era.

As the comic above shows, the situation is made worse by the fact that Barack Obama holds presidency and that the republican party hold a majority in the House of Congress. Therefore it makes it very difficult for decisions to be made, as the republicans can out-vote Barack Obama’s laws. When the republicans want taxes to be cut and the democrats are promoting higher taxes (especially on the rich) this can lead to a devastating conundrum.

Surely tax rises and spending cuts are good in these austerity times?

Well that may be the case, but the sheer level of the fiscal cliff is the result of all this fear.

Should the Government let this cliff occur the budget deficit is looking to half (as a % of GDP), this can have serious implications on the rest of the economy; as government spending will significantly decrease. The defense budget and medicare are pin-pointed to be receiving the biggest blow to their income as a result of this.

Why not cancel all the tax raises and spending cuts?

This is certainly an option, but not a very wise one. The USA is already holding national debt of around 100% of GDP (est. $15,000 billion) (debt chart) and the fear is if they reverse the effects of the fiscal cliff, that debt in the USA will continue to rise substantially and follow a similar crisis as the situation in Europe (It’s worth noting though, in comparison, Spain’s debt is only 85.3% of their GDP; but their situation is worsening).

What option do they have?

It seems the best option they can take is to adopt a middle ground position. Allow some of the tax rises and spending cuts to take effect, but to the extent that it only has a small impact on USA growth and enough of an effect to reduce the budget deficit and national debt to avoid a crisis similar to Europe.

Whats happening in the markets now, as a result of the Fiscal cliff?

  • Stock Market. Since Barack Obama’s re-election the stock market has seen some large losses, the Dow Jones (DJIA) fell from a high of 13,245 (on Nov. 6th) to a low of 12,542 (15th Nov.) and now settles on 13,000. This can be attributed uncertainty, due to the fact that the Republicans hold the House of Congress and therefore make it very difficult for Barack Obama to bring forward new laws, especially relating to the Fiscal Cliff, where political differences are vast.
  • Dividends. We’ve seen a big increase in the number of companies offering ‘special dividends’ so as to avoid the expected tax rises on some dividend earners. These special dividends are designed to be paid before 31st of December and aren’t uncommon, as there is always a series of tax rises/cuts and spending cuts/rises in the USA on that date. But we’ve seen a much larger proportion of companies undertaking the practice this year, which could hint uncertainty about what the Obama administration will do.
  • Treasuries in the US. Advanced after demand for 5 year notes reached peaks not seen for 8 years (Source: Bloomberg). The reason why the US treasuries attract attention is that bonds tend to be a safe-haven in times of uncertainty, and the vast demand for US treasuries shows that investors are un-sure of what the fiscal cliff will bring (See bottom if you are unsure what a treasure note is).
  • Value of US Dollar. We’ve seen a depreciation (fall) in the value of the US dollar, as money moves out of the USA as investors fear that the fiscal cliff will have a negative effect on the US economy and therefore move their money to ‘safer’ areas.

The euro on the 6th of November was trading at €1 = $1.281889 (mid-market rate) and today, the 29th of November, the euro is trading at €1 = $1.297742.When the Euro is going through a rough patch it is interesting to see an appreciation of the Euro to the Dollar of 1.24%. For companies trading $billions between Europe and America that could have a profound effect on their business.

We all anticipate the result, however I very much doubt there will be any kind of apocalyptic disaster as some media outlets suggest. It seems that in these current fragile times it is unlikely that the US Government will let the tax raises and spending cuts go ahead in full extent; I imagine a middle ground will be established.

Until then we must sit tight and consider whether it’s worth shorting the markets over Christmas.

-Ed

–A little about Treasuries: Treasury notes are similar to Gilts in the UK, they are US government debt bonds that pay a specific coupon rate (interest rate) for a certain number of years until their ‘maturity’. Upon maturity the holder of the Treasury note will receive the ‘face value’ (original amount paid for the bond) in full.

For example; a 5yr-note goes on sale on 1st November 2010 for $1,000 with a coupon rate of 10%.

The buyer of the note pays $1,000 and subsequently receives $100 for 5 years, totalling $500. They then receive their original $1,000 back upon maturity (1st November 2015).

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