Sequester Fester, No Cliff

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 |  Includes: FXE, SPY, UDN, UUP
by: Marc Chandler

The political paralysis in the U.S. means that the $1.2 trillion in spending cuts are set to go into effect with an $85 bln in cuts during the remainder of the current fiscal year. Assuming that every dollar cut in spending reduces GDP by a dollar, the sequester will shave U.S. growth by around 0.5% this year.

However, the way households will be impacted will be a function of their reliance on the federal government: The greater the reliance the greater the impact. The spending cuts seem rather arbitrary, though evenly divided between defense and civilian activities.

A recent Pew poll found that less than 1 in 5 Americans understand how they will be personally impacted by the sequester. This warns of the risk of some negative surprises. It may mean more than simply frustrations with longer lines at the airport security, for example.

The sequester itself is a bit of a farce in the sense that it was never intended to be enacted. It was purposely designed to be absurd to give the political class incentive to find an alternative. Yet what appears to have happened is that the players (the President, Democrats in Congress and Republicans in Congress) did their political calculus and have concluded that the sequester is preferable to the other realistic alternatives.

The polls show that American people will blame the Republicans more than the Democrats. Obama has insisted that the spending cuts should be coupled with new measures to raise revenue and the Republicans do not think greater concessions will help them.

What does it mean for investors? The U.S. stock market is at 5 year highs. It has indeed climbed a wall of worry. What has been lifting the stock market does not seem to be the traditional macro-fundamentals of valuation but liquidity.

As Fed Chairman Bernanke made clear in his testimony this week, QE3+ will continue. The sequester and the new anxiety in Europe seems to have reinforced his commitment to continued monetary stimulus. Ironically, the $85 bln in spending cuts this fiscal year is the amount of monthly long-term asset purchases by the Federal Reserve.

The U.S. 10-year yield has generally trended higher since late last July when ECB President Draghi upped the ante to reduce the extreme tails risks in Europe. This reduced the need for safe haven. U.S. Treasuries, alongside other core bonds and safe havens (such as the yen and Swiss franc), weakened.

However, twice in recent weeks the 10-year yield rose above 2% only to be rejected. The down shift in U.S. growth, the commitment to continue QE3+, and the anxiety in the aftermath of the Italian election has seen U.S. yields ease off. The dividend yield of the S&P 500 is about 2.15%.

For its part, the dollar's performance since QE3+ was announced in mid-Sept is open to interpretation. As Orson Welles once remarked, "If you want a happy ending, that depends of course, on where you stop your story." From mid-Sept to the eve of the sequester, the net change in the dollar is not quite what one would expected if one assumes that the foreign exchange market has been driven by QE3+.

The euro is up 1.5%, the yen is off 15.6% and sterling is off 5.8%. The Canadian dollar is off 5%. Looking at other important U.S. trading partners, the Mexican peso is up almost 2% and the Chinese yuan has gained about 1.7%.

Our sense is neither QE nor the sequester is the main driver of the dollar's exchange rate. The fact that the passive tightening in the euro area is not as great as feared and that Italian voters became the first to seemingly reject the Brussels-German led austerity in Europe (arguably the 2012 was similar rejection of a hair shirt regime by American voters) did much to lift the U.S. dollar against the euro. Meanwhile the aggressive monetary and fiscal stimulus the new Japanese government promised and the reduced need for a safe haven in Q4 12 and earlier this year, helped lift the dollar against the yen.

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.