How Will Markets Discount The 'Fiscal Cliff'?

Includes: FXE, UDN, UUP
by: Ralph Shell

When confronted by a forthcoming risk event, markets will often weigh the pros and cons of an anticipated outcome. Price will be determined by the collective judgement of the market appraising the involved risk. Once the outcome of the event is known, the market is relieved, and any risk insurance that had been priced into the market is taken out.

This may have been the situation with the euro strength over the past week. Worried about the outcome of the Greek debt bailout, the EURUSD staged a rally from under 1.27 to above 1.29. When it was announced the Finance Ministers had cobbled together an agreement that would buy enough time to get past Chancellor Merkel's German reelection, the pair then briefly traded above 1.30, and then sold off.

It seems like the "buy the rumor and sell the news" trick, but it's best to consider the revelations in the latest COT report. This report shows that the large specs increased their short positions during the preamble to the latest Euroland summit. Further, for the first time since the August 21 COT report, specs had flipped their position to long the USD. It looks like the run-up in the euro and the yen was sold by professional specs.

Currently, the U.S. economy seems to be muddling along. The U.S. GDP Annualized Q/Q is due to be released Thursday, November 29th. The consensus estimate is for a 2.8% growth rate, which seems a little high to me, but nonetheless, better than either Europe or Japan.

As we approach December, the next big risk event that will worry the market will be the "fiscal cliff." The cliff arrives in the new year when tax cuts expire and mandatory spending cuts begin. Should the politicians fail to achieve a compromise and we begin the type of austerity that has been tried in Europe, it is estimated the result would be a 1 or 2% reduction from the current GDP growth rate.

With the potential for grave harm to be inflicted on the U.S. economy, it seems logical a compromise should be reached. Such may not be the case. Some politicians are looking forward to the fight, and should this result in a recession, they will then blame the other party for the harm. Here are recent comments made by Patty Murray (D) from Washington:

"Millions of jobs could be lost through the automatic cuts, programs families depend on would be slashed irresponsibly across the board, and middle-class tax cuts would expire. And once again, if Republicans won't work with us on a balanced approach, we are not going to get a deal," said Senator Murray, the Senate's No. 4 Democrat, in a speech at the Brookings Institution on Monday.

"[I]f we can't get a good deal - a balanced deal that calls on the wealthy to pay their fair share -- then I will absolutely continue this debate into 2013, rather than lock in a long-term deal this year that throws middle-class families under the bus," she said.

From these comments, Senator Murray is obviously willing to drive off the cliff, harming the economy, if she thinks she can blame the subsequent recession on the Republicans and gain 2014 votes. It is important to remain alert for others that might agree with Murray. Markets are unlikely to fare well as they watch the brinksmanship leading up to the cliff.

We are already getting indications that some Republicans are willing to compromise on higher taxes for the top earners. If there is a chance of higher taxes, then can higher taxes on capital gains and dividends be far behind? This threat may lead to some year-end selling of equities.

So equity markets have multiple worries, uncertainty about the fiscal cliff, higher taxes, and the possibility of slower growth in 2013. Where does that leave the USD?

Ironically, really bad developments might be friendly to the USD over the short term. In a risk-off climate and slowing emerging market growth, the USD may appear like a safe haven. Further, even with a reduced rate of growth, the U.S. economy will be growing faster than the rest of the industrialized world. Longer term, a slower U.S. growth rate would be a drag on the currency, probably bearish on the USD.

Is there a trade in the EURUSD? (FXE, UUP) In this type of an environment emotions can carry the pair market further than one might expect. We are inclined to take either side of this market at the right price. At 1.28, we would be a buyer, and we would try the short side on a return to the 1.30 handle.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.