The Fiscal Cliff - How Will It Affect Interest Rates?

With yet another economic crisis looming on the horizon, this time in the form of the Fiscal Cliff, how will interest rates react if negotiations fail?

Markets hate uncertainty. Job markets, capital markets, it doesn’t matter what type of market is the object of our scrutiny, the visceral loathing of uncertainty by market participants remains an unvarying theme. With the presidential election now complete and little about the composition of Washington D.C. changed –the same leaders and the same parties occupy the White House, the House of Representatives and the Senate- the uncertainty surrounding who will lead our country and what their associated policies will be has been removed. Another uncertainty looms large, however, the automatic tax increases and spending cuts that comprise what has become known euphemistically as the Fiscal Cliff.

The Fiscal Cliff dates back to the Joint Selection Committee on Deficit Reductions, a body also labeled with a handy euphemism, the “Super Committee”. Constructed by Congress in the Summer of 2011, it was tasked with ways to eliminate $1.5 trillion worth of cuts from the projected deficits of the next decade. Concerned the committee might fail in its endeavor, a backstop was emplaced comprised of $1.2 trillion in spending reductions as well as an end to the Bush era income tax cuts and the Obama era payroll tax cuts, all of which would automatically kick in on January 1st, 2013. Predictably, failure ensued, and the Fiscal Cliff has been lurching toward our already struggling economy ever since. According to the non-partisan Congressional Budget Office (CBO), the combination of spending cuts and tax increases would result in over $500 billion being trimmed from the deficit by September 2013. Good news, right? Not so fast. This drastic implementation of austerity measures would also result in a projected contraction of GDP by 0.5% and potentially the loss of millions of jobs. The cuts would lead to roughly the same amount of economic contraction currently being suffered by Europe where austerity efforts have proven to be remarkably unsuccessful in reducing debt levels or in controlling the cost of sovereign debt, while inflicting massive damage upon the EU economy as a whole, and obliterating the Greek and Spanish economies in particular. Perhaps austerity is not such a great idea after all, at least not all at once.

Is the threat posed by the Fiscal Cliff to our economy of the magnitude being presented to the public by our politicians and the press? Or is it hyperbole, scare tactics meant to push the agenda by one side or the other? Conventional wisdom is that an impasse would be disastrous as a failure to reach a deal would result in the shattering of the fragile economic recovery and a plunge back into a recession. Clearly the lack of an agreement by January 1st would be less than ideal, but its impact might not be as cataclysmic as some might have you think. The Fiscal Cliff is really more of a Fiscal Slope. The idea that all of these tax increases and spending sequestrations will really be enacted simultaneously on the 1st of the year is a myth. Government does not move that quickly nor do its various entities operate in concert with the effectiveness such a conclusion would imply. That said, Europe can be used as an example of what might happen should an agreement not be reached prior to the end of the year.

Sovereign debt yields will rise in the short term as investors become leery of the stability of our economy. Predictions of a resultant recession immediately following the 1st of January have been issued by too many for too long for interest rates not to be affected. For those looking to buy a home, this means higher mortgage rates, which will put a damper on both the mild resurgence in home sales and the sharper increase in mortgage refinances that we have seen over the past year. For security investors, this will represent good news. Interest rate payouts on mortgage backed securities (MBS) and certificates of deposits (CDs) will go up, so savers, who have been getting little or no return for years on their investments, might actually benefit from the lack of a budget deal. Still, an increase of a few basis points in yield on such investments seems a small gain in exchange for another economic crisis, particularly one that can be avoided if the politicians on both sides agree to a compromise.

Compromise is an epithet in Washington these days though, and no mandate was achieved on November 6th, emboldened Democratic posturing to the contrary notwithstanding. With the warring parties still far apart on tax levels to be imposed on the wealthiest strata of Americans, the crisis is likely to drag on. For investors looking to take advantage of a potential spike in interest rates come January, ensuring you have sufficient liquidity to do so would seem to be a good idea as even a short term crisis, one eventually resolved before the full Fiscal Cliff unfolds, will likely generate deals on yield revenue dependent securities.

Michael Cancella
Michael Cancella: Michael Cancella graduated magna cum laude from Columbia University with a B.A in History in 2010. After graduating he worked in the finance industry at a hedge fund startup and is currently going through the CFA Program in an effort to broaden his knowledge of finance and the economy. Prior to returning to school to finish his degree at Columbia, he spent a number of years i

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  • Michael Cancella

    November 22, 2012

    Sol, I used the qualifier "short term" in reference to interest rate spikes, because I think markets will do what they always do when something like this occurs: over-react. If we actually go over and stay over the Fiscal Cliff, that's another story. But I don't think we will, the politicians will figure out a way to kick the can down the road and everyone will pretend that represents a resolution.

  • Sol

    November 24, 2012

    Going over the fiscal cliff will depress the economy, lowering rates. Rates will drop further because the fiscal cliff, while slowing the economy, will result in lower budget deficits. This has been confirmed by CBO projections. So the fiscal cliff will depress rates which is good for borrowers but not good for savers.

    There are even some economists who believe that the economy can go over the cliff and still grow, albeit more slowly. GDP growth is projected to be in the 2-3% range over the next couple of quarters and that may be enough to grow even with the cliff.

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