Thoughts on the US fiscal cliff ‘deal’

Whilst the eleventh hour agreement on the US fiscal cliff effectively pulling the United States back from the precipice and the avoidance of the fiscal cliff does provide some real relief, most notably making permanent the Bush era tax cuts for households making less than $450,000, the deal was not the grand bargain that many had hoped for. Instead it ushers in what will likely be a bitter debate over how to deal with the trajectory of ever growing entitlement spending.

The deal as reached cut spending by roughly $24bn over the next ten years, and additionally, Congress created a mini-cliff by pushing the budget sequestration to February 28^th, and in keeping the debt ceiling out of the fiscal cliff deal, the Republicans have in effect retained a means by which to attempt to force spending cuts.

President Obama had suggested some items to reduce entitlement spending in his offer of December 17^th and there’s an expected debate on a switch to chained CPI as well as means testing for Medicare, but these two items together do not net $1tn and the Republicans are likely to push for one dollar in spending cuts for every dollar increase to the debt ceiling. Entitlement reforms look to be the bargaining chip in negotiating ht debt ceiling, but we may doubt that the administration wants to set a precedent of trading spending cuts for each increment up in the debt ceiling and the president has made clear his determination that the debt ceiling should not be used as a negotiating tool. He may therefore seek to shift the blame to Republicans by asserting that he would rather shut down the government than jeopardize the debt. Alternatively, with an eye to avoiding annual bruising encounters, the president may seek to adopt permanently the McConnell plan for the debt ceiling in exchange for entitlement reforms. Back in 2011, Senator McConnell, the Republican minority leader, unveiled a complicated legislative strategy that would allow Congress to vote against raising the debt limit, let President Obama veto the measure, and then hold a vote to override the veto, which requires a two-thirds majority to pass. The proposal was designed to avert Federal default while pinning political responsibility for raising the debt limit on those who agree to do so–likely the president and his fellow Democrats. The plan allowed for the Republicans to vote against a debt-limit increase, without risking debt default, with Congress could pass a “measure of disapproval” to reject the request for more money, and Mr Obama then vetoing  that measure with the result that his request would be de facto approved. The veto could only be overridden by a supermajority in both houses of Congress.

Despite the gloomy fudge implied, it’s worth noting that even without significantly addressing outlays, the current agreement could bring the projected deficit as a percent of nominal GDP toward 3% by 2015, given reasonable economic growth, bringing the deficit back to the sorts of level seen during the late 1980s.

In terms of the immediate implications for bonds, we should not expect this deal to affect issuance for now, but if there are substantial cuts to spending, be it via sequestration or entitlement overhauls, the repercussions may be larger, especially for bills in the years ahead. Meanwhile, given where we are, the Credit Rating Agencies are likely to become more focused on the possibility of technical or short-term US government debt default. The ratings agencies put the US government on Review/Watch in summer 2011 as the Debt Ceiling approached, and resolution of the Debt Ceiling in early August led Moody’s and Fitch to revert to Negative Outlooks on the US credit rating, while S&P downgraded its rating leaving the negative outlook. We can expect all three agencies to revert to negative outlooks after this year’s Debt Ceiling debate, which will likely include some incremental spending cuts and a change in sequestration which will also help to marginally improve the deficit picture further. More optimistically, if the debt ceiling debate brings further spending cuts and results in an increase to the debt ceiling that would last more than a year, the rating agencies may be hesitant to downgrade US government debt. With all three agencies, the amount by which the ceiling increases and any reductions in spending will likely play key roles in their ultimate decisions.

Against the backcloth, there’s a risk that US ten year bond yields drift higher over the quarter, perhaps to 2.25%.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla