What is the US Fiscal Cliff? How will the US Dollar react?
The US risks seeing an already weak economic
recovery fade away as it has so far been unable to find a solution to a
series of automatic cuts and tax increases, referred to as the “Fiscal
Cliff”, that will take effect as at January 2013.
Define:
The term “fiscal cliff” refers to a combination of both spending cuts and tax increases due by early 2013in the US. The tax increases are resultant from a number of previously introduced tax cuts that will reach expiration by the start of 2013, while the spending cuts are mostly being triggered by the sequester.
The sequester is a budgetary enforcement tool originally introduced in 1985 which has seen added interest recently since it was also included for enforcement within the Budget Control Act of 2011.
In August 2011 US Congress had agreed to raise the US debt limit but the deal also included provisions for spending cuts and a Joint Select Committee was asked to come up with another $1.2 trillion in deficit cuts spread over ten years. This committee, however, failed to reach this aspired target in November2011.
Following the failure of the Committee it is envisaged that the sequestrations will be triggered as part ofthe enforcement of the 2011 Act. The sequester is thus an automatic flat $109 billion yearly cut inspending, to take effect on January 2nd, 2013, designed to force Congress to achieve a balanced deficitreduction plan. These automatic cuts are imposed across a number of federal programs and will havethe effect of tightening fiscal policy at a time when the economic recovery seems as yet unable to standon its own feet.
Why should this bother you as an investor?
The Congressional Budget Office (CBO) estimates that the combined effect of the spending cuts and tax increases plus the resultant economic feedback could result in a fiscal contraction in the region of $560billion between 2012 and 2013 and the magnitude and the timing of such a contraction will most certainly hit US GDP growth negatively. The US is the largest global economy so imagine what dampening effect that would have on the rest of the world economy - you will have come across a saying if the US sneezes the rest of the world will catch a cold.
Forex investors holding exposures in the US Dollar will also be affected by currency fluctuations – one will have to see how events will feed into currency market behavior.
The US faces a choice between:
1) Build a stronger fiscal position and growth in the long run but jeopardize short term growth and an already doubtful recovery by allowing the tax increases and spending cuts to come into effect. The CBO projects that calendar year 2013 growth would be reduced to 0.5% thereby increasing the possibility of recession.
or
2) Avert short term negative impact by avoiding the measures forming the main components of the fiscal cliff at the cost of higher debt and interest payments whilst increasing the risk ofseeing the US face a crisis similar to what the EZ is facing. In this scenario CBO estimates projected GDP growth for the calendar year of 2013 to be in the region of 4.4%.
The choice between these alternatives is already quite bleak but it is worsened by a political inability to find common ground in an election year (elections are due November this year). Given the sensitivity of the issues involved i.e; tax increases, spending cuts etc. we are faced with a Congress that so far was unable to make it through this bottleneck.
How will the US Dollar react?
Whilst overall ,at a first glance, one should expect such event risk to weigh on US Dollar’s support this should be somewhat balanced against the safe haven role the USD tends to have.
However the effect on the US Dollar will largely be a function of what political response the US government will in the end resort to.
A reactionary approach, as opposed to a proactive approach, should be expected to impact negatively on the USD; kicking the can down the road is something that the EZ is accused of and we have seen the effects on the euro. On the contrary a clear direction for the deficit cuts required over the ten year period should be positive for the US Dollar.
With the US having to digest an election, a seemingly faint economic recovery and the threat of debt and further downgrades it is likely that US policymakers will remain uninterested in a strong USD. If we had to focus on the EUR/USD the lead that the USD has been holding against the euro since May’11probably opens the door for some correction. So while downside risks remain for the pair we could most probably be aiming for levels around 1.30 levels in the coming year.
Conclusion
Will the US avert this fiscal cliff? Probably yes but this will now depend heavily on how policy makerstackle the upcoming elections, this fiscal conundrum and the resultant consequences on the market.Investors will be eyeing to what extent policy makers can remove the uncertainty associated with the fiscall cliff and how swiftly they can make this happen.
Define:
The term “fiscal cliff” refers to a combination of both spending cuts and tax increases due by early 2013in the US. The tax increases are resultant from a number of previously introduced tax cuts that will reach expiration by the start of 2013, while the spending cuts are mostly being triggered by the sequester.
The sequester is a budgetary enforcement tool originally introduced in 1985 which has seen added interest recently since it was also included for enforcement within the Budget Control Act of 2011.
In August 2011 US Congress had agreed to raise the US debt limit but the deal also included provisions for spending cuts and a Joint Select Committee was asked to come up with another $1.2 trillion in deficit cuts spread over ten years. This committee, however, failed to reach this aspired target in November2011.
Following the failure of the Committee it is envisaged that the sequestrations will be triggered as part ofthe enforcement of the 2011 Act. The sequester is thus an automatic flat $109 billion yearly cut inspending, to take effect on January 2nd, 2013, designed to force Congress to achieve a balanced deficitreduction plan. These automatic cuts are imposed across a number of federal programs and will havethe effect of tightening fiscal policy at a time when the economic recovery seems as yet unable to standon its own feet.
Why should this bother you as an investor?
The Congressional Budget Office (CBO) estimates that the combined effect of the spending cuts and tax increases plus the resultant economic feedback could result in a fiscal contraction in the region of $560billion between 2012 and 2013 and the magnitude and the timing of such a contraction will most certainly hit US GDP growth negatively. The US is the largest global economy so imagine what dampening effect that would have on the rest of the world economy - you will have come across a saying if the US sneezes the rest of the world will catch a cold.
Forex investors holding exposures in the US Dollar will also be affected by currency fluctuations – one will have to see how events will feed into currency market behavior.
The US faces a choice between:
1) Build a stronger fiscal position and growth in the long run but jeopardize short term growth and an already doubtful recovery by allowing the tax increases and spending cuts to come into effect. The CBO projects that calendar year 2013 growth would be reduced to 0.5% thereby increasing the possibility of recession.
or
2) Avert short term negative impact by avoiding the measures forming the main components of the fiscal cliff at the cost of higher debt and interest payments whilst increasing the risk ofseeing the US face a crisis similar to what the EZ is facing. In this scenario CBO estimates projected GDP growth for the calendar year of 2013 to be in the region of 4.4%.
The choice between these alternatives is already quite bleak but it is worsened by a political inability to find common ground in an election year (elections are due November this year). Given the sensitivity of the issues involved i.e; tax increases, spending cuts etc. we are faced with a Congress that so far was unable to make it through this bottleneck.
How will the US Dollar react?
Whilst overall ,at a first glance, one should expect such event risk to weigh on US Dollar’s support this should be somewhat balanced against the safe haven role the USD tends to have.
However the effect on the US Dollar will largely be a function of what political response the US government will in the end resort to.
A reactionary approach, as opposed to a proactive approach, should be expected to impact negatively on the USD; kicking the can down the road is something that the EZ is accused of and we have seen the effects on the euro. On the contrary a clear direction for the deficit cuts required over the ten year period should be positive for the US Dollar.
With the US having to digest an election, a seemingly faint economic recovery and the threat of debt and further downgrades it is likely that US policymakers will remain uninterested in a strong USD. If we had to focus on the EUR/USD the lead that the USD has been holding against the euro since May’11probably opens the door for some correction. So while downside risks remain for the pair we could most probably be aiming for levels around 1.30 levels in the coming year.
Conclusion
Will the US avert this fiscal cliff? Probably yes but this will now depend heavily on how policy makerstackle the upcoming elections, this fiscal conundrum and the resultant consequences on the market.Investors will be eyeing to what extent policy makers can remove the uncertainty associated with the fiscall cliff and how swiftly they can make this happen.
