After having been diverted from driving over the cliff, the US economy is now being driven down a very muddy road and after all the rain that the UK has had over the past month I certainly know how slow that makes things.
A quick summary of the compromise deal that the US Senate negotiated and the House of Representatives has grudgingly approved is as follows:
- $620bln in raised revenue over the next 10yrs.
- Permanently extends tax cuts enacted in 2001 under former Republican President George W. Bush for income below $400,000 per individual, or $450,000 per family. Income above that level would be taxed at 39.6pc, up from the current top rate of 35pc.
- Above that income threshold, capital gains and dividends tax rates would return to 20pc, from 15pc.
- Caps personal exemptions and itemized deductions for income above $250,000, or $300,000 per household.
- Raises estate tax rate to 40pc for estates of more than $10m per couple, up from the current level of 35pc.
- Includes a permanent fix for the alternative minimum tax.
- Extends unemployment insurance benefits for one year for two million people.
- Extends child tax credit, earned income tax credit, and tuition tax credit for five years.
- Extends research and experimentation tax credit, and the wind production tax credit through the end of 2013. Extends 50pc bonus depreciation for one year.
- Avoids a cut in payments to doctors treating patients on Medicare – the “doc fix.”
- The removal of the 2% temporary cut in Social Security payroll tax – means approx $1,000 tax increase for someone earning just $50,000
It does not address spending or the Treasury debt ceiling which was hit on December 31st.
The automatic spending cuts will be pushed back to March 1st, and the temporary measures to keep the US Treasury from defaulting will run out somewhere at the end of February beginning of March.
So now we have two months of political posturing and fighting over the spending cuts and probably 7 weeks over the debt ceiling . The new US congress convenes tomorrow. This is not a deal to move the US economy forward. With no deal on spending cuts then there is still a huge uncertainty in business deals and the raising of the Social Security Payroll Tax will hit consumer confidence and spending on everyone.
The market reaction is confused- US Treasury Bond and US Equity futures do not open until 11:00 am GMT. So for the moment liquidity is near enough nonexistent.
German Bunds and European equity markets are catching up with the US market reaction from Monday- which saw US equities around 1% higher since the German DAX closed on Friday. With the DAX higher by 1.9% this morning it would suggest that the US equities should be higher again today. However the European markets are more risk sensitive these days given the sensitivity to the peripheral debt markets. So I think that the US markets will probably only open up slightly maybe 0.5%-0.75%.
German Bunds have fallen back- the 10yr yield differential to the US opened at 42bp this morning but is now close to 38bp and 30yr Bunds are lower by 2.75 points, or 13bp higher in yield.
With 10yr US yields above 1.80% and 30yrs above 3% then there will have been some stop loss selling this morning. Only a break above 1.85% on 10yrs would be seen as leading to a technical breakdown and a move towards 2%.
However the fundamentals do not point to higher yields as of yet.
Whilst Commodity markets have reacted positively to the passage of the “Big Compromise” they still show no signs of breaking out of the recent ranges and leading to higher inflation expectations in the US.
That is mirrored in the bond market reaction over the past weeks. Given the continuation of QE in the US the Treasury market has sold off more than the level in inflation swaps would suggest.
It suggests that the 5yr versus 10yr yield curve in the US is too steep. And that 10yr US Treasury yields should not break higher here.
Interest Rate Implied Volatility remains elevated and although Implied Volatilities have fallen this morning they still remain above mid December levels.
For me to have any confidence in risk markets to continue to rally, it is these levels that need to fall.
The only concern I have in US Treasury yields not falling from here is the price information from the Philadelphia Fed Survey.
The recent rises in both current prices received and 6 months forward expected raise some concerns if they continue as they reduce the Fed’s willingness for QE to continue.
What to expect from here– in 2011 S&P cut the US AAA rating because of the political wrangling over the debt ceiling. With only modest tax rises and no definitive spending cuts and after all the political wrangling the rating agencies must be ready to move again.
Last time that hit risk markets more than US Treasury markets. 10yr US Treasury yields fell a huge 90bp in the following 2 months after the August move by S&P.
It oddly saw US Treasuries outperform all other AAA bond markets.
So for the time being I continue to see 10yr US Treasuries remaining in the same range as they have been since August , 1.85%-1.60%
That makes them a buy here with a tight stop loss at 1.87% I would suggest.
Risk markets are similarly in a wide range of the S&P 500 in a 1445 to 1360. It may be that the S&P opens close to the top today but I would then expect the markets to sell off.
Happy New Year and Good luck for 2013 to everyone.