Closed-door meetings are underway to delay the U.S. fiscal cliff. Nonetheless, uncertainty regarding fiscal policy is already undermining the economy and it could very well culminate in financial market riot points.
A “grand bargain” package of tax increases and spending cuts aimed at reducing the U.S. structural budget deficit is highly unlikely this year, especially if President Obama wins re-election. Policymakers could not strike a deal last year, and the two sides are just as far apart today. However, there are bi-partisan closed-door Senate meetings underway to avoid or delay by 3-6 months the sharp tax increases and spending cuts scheduled to take effect in early January.
A deal that buys more time for negotiations would be bullish for risk assets because it would kick the (fiscal cliff) can down the road. However, our geopolitical strategists believe that such a deal to delay the Cliff is unlikely before the election, which means that the uncertainty will continue to hang over markets in the near term.
Moreover, there is little incentive for a GOP-led House to agree to a delay during the lame duck session. We expect that the fiscal cliff will ultimately be postponed, but it still appears that it will go down to the wire in late December.
The tight correlation between policy uncertainty and bond yields since 2009 illustrates the potential for volatility after the election, especially if President Obama wins because the highly confrontational nature of the fiscal debate will continue.
Bottom line? We will likely trim exposure to risk assets before the end of the year.