Markets’ Initial Reactions to the New Fiscal Compromise
Financial markets have reacted to the new tax cut deal between the White House and Congressional leaders which would add some $800-900 billion to our national debt.
In the past two trading days since the deal was announced, we have seen the largest bond sell-off this year and so interest rates have gone up fairly dramatically. So far, yields on the benchmark 10 year Treasury bond have jumped by over 35 basis points (considered a sizeable rise), to the highest point since June. Money has shifted to the stock market, and the dollar is higher.
Bond sales over the past few days appear to have been initially driven by an improved assessment of US growth prospects. Investors’ initial read of the tax package appears to be that it would boost US growth in the short run, which will mean greater upward pressure on interest rates from stronger economic activity than anticipated. A shift in expectations for higher interest rates normally hurts bonds and, as we’ve been seeing yesterday and today, helps stocks.
But hovering in the background is the 500 pound guerilla - our fiscal imbalances. The new deal could add some $800–900 billion (around the size of the 2009 stimulus package) to our national debt over the next two years, according to some very preliminary estimates. (Some market commentary has put the package at $1 trillion, citing the credit ratings agencies Moodys and Fitch as sources.) Debt is already at the highest share of the economy since the immediate aftermath of World War II, well above its 40 year average, approaching points that some experts associate with increased risks, and is projected to rise forever unless we change our fiscal policies. The tax package, while boosting short-run growth, will make our fiscal challenges and choices even tougher down the road. Concerns that the tax package could be a further blow to the US fiscal position have already been expressed by the credit ratings agencies Moodys and Fitch (although Moodys later clarified that no ratings downgrade was in the works). Still, the issue may be assuming a slow burn: some market commentaries have started to observe that along with Germany, the United States is the only major advanced industrial country not to have a fiscal recovery plan in place.
Going forward, just what are the fiscal intentions of the White House and Congress? At some point, the markets will want – and need – to know. In contrast to the tough deficit hawk rhetoric from many quarters in the aftermath of the Fiscal Commission’s report only last week, the new tax cut compromise send out mixed signals - to say the least - about the direction our policymakers will now want to take. But we may have to wait until February to see intentions clarified, when the White House proposes its new budget to Congress. How, for example, will our policymakers pay for the huge tax cut program they have just negotiated? February can’t come soon enough.