Talks on the fiscal cliff have resumed, but as of this writing there is not yet an agreement. The current negotiations focus on the income threshold under which tax cuts should be extended, among other topics. As we have noted, the sides seem as far apart as ever, and as Goldman notes, while it is still possible that an agreement will be reached by year end, a retroactive deal in January looks more likely. The eventual resolution still looks likely to be a scaled down agreement that addresses only the policy changes scheduled for year-end and omits other issues, such as an increase in the debt limit or longer-term fiscal reforms. The greatest area of uncertainty is whether the spending cuts scheduled under the sequester will be addressed. The fiscal policy timeline below shows how we are rapidly approaching the more ominous debt ceiling debate and Goldman’s Q&A asks and answers provides context for where we are from both an economic and ratings agency impact basis.
Scenario Analysis (Via Citi’s Steven Englander):
The most likely FX/fiscal cliff outcome is a combination of limited fiscal progress and very easy money that will likely be USD negative. This may be why the S&P sell-off has generated limited USD weakness so far:
Expectations for fiscal cliff outcome are converging on one of three scenarios, each of which has strong USD-negative implications:
- a nasty, brutish and small fix by midnight December 31st;
- a quick drop over the cliff that gets resolved before this Congress ends at noon January 3
- the new Congress manages to pass an even more limited fix early in its session.
The fiscal outcome of each of these is likely to contain very limited long-term deficit reduction and expenditure control, but enough short term fiscal restraint to keep the Fed oriented to its very easy money policy orientation. It is also likely to lead to a US credit downgrade. This combination of outcomes will not be risk-off enough to generate safe-haven USD buying, will raise concerns over long term US fiscal sustainability as well as the political ability to deal with the fiscal imbalance, and stoke expectations that Fed ease will be with us for a long time.
With S&P futures closing at 1384 it has now retraced about 2/3rds of the way back from its post-election 1441 peak to its 1344 November 15 trough. However, even on November 15, investors were far from pricing in certainty of a hard fall over the fiscal cliff, so it remains the case that we would get a much bigger drop if there such a hard fall over the cliff emerged. When the S&P was at its early-June low of 1278, CAD was at 1.04, AUD at 0.97 and MXN at 13.75, and it still remains very likely that further significant S&P weakness would bring more pressure on these risk-correlated currencies than we have seen so far.
If I am correct above, investors are still pricing in a moderate recovery, easy money and ongoing political confusion – a hard fall over the cliff would quickly shift this scenario to outright panic and this would be much more positive for the USD than anything we have seen recently.
Q&A and Timeline (Via Goldman Sachs):
Q: Where do things stand now?
A: Talks have resumed, but as of this writing there is no agreement yet. President Obama and congressional leaders met this afternoon to discuss the possible next steps that might be taken to avoid the fiscal restraint set to take effect at year-end. It seems likely that Senate Majority Leader Reid (D-NV) will bring up legislation on the Senate floor at some point before the end of the year, but it is not yet clear whether that will be the product of a bipartisan compromise reached with Republican leaders and the President, which would have a chance of passing both chambers of Congress, or a proposal supported only by Democrats, which would be less likely to pass in either chamber, particularly the House.
Q: Will there be an agreement by year-end?
A: It is still possible but a retroactive deal in January looks more likely. With little time left before year end, there are two obvious obstacles to enacting an agreement by that time: the lack of a political agreement, and the short time left on the calendar to get any agreement that might be reached enacted into law. Reaching a political agreement is the tougher part. It is conceivable that Senate Republicans could allow a compromise dealing with the middle-income tax cuts and a few other items to pass in the Senate; this would happen if Republicans refrained from objecting to consideration of a bill, allowing it to pass with a simple majority (i.e., most of the 53 Senate Democrats) rather than the 60-vote supermajority that has become customary for major legislation.
However, House Speaker Boehner has stated that he will not support a plan that involves passing legislation in the House with mostly Democratic votes. This may become less of a constraint after year end, since (1) taxes will have risen, allowing both parties to claim that the agreement is a “tax cut,” (2) the House will vote to choose its speaker January 3, after which it may be easier for Speaker Boehner to allow legislation to pass with mostly Democratic votes, and (3) public pressure on lawmakers will have increased, making them more willing to compromise.
In the somewhat less likely event that an agreement is reached before year-end, the logistics of passing it in the House and Senate will take a bit more time, but will be less relevant. Most market participants and the broader public are likely to respond more to the news of an agreement rather than the particulars of the legislative process that follows. Second, while passage using normal legislative procedures could take over one week, passage could be accomplished in just a few days if there is political will to do so.
Q: If an agreement is reached, what would it look like?
A: Probably a scaled-down deal. At this point, the most likely solution prior to year end (or in the first few days of 2013) would be enactment of a scaled-down agreement that addresses only the policy changes scheduled for year-end and leaves for later other issues, such as an increase in the debt limit or longer-term fiscal reforms. This might involve an extension of the 2001/2003 tax cuts for income under $400,000 or $500,000 (including capital gains and dividend tax rates at 15% for taxpayers with income under that level and a 20% rate above), relief from the alternative minimum tax (AMT) for 2012, and extension of emergency unemployment benefits, which are scheduled to expire at year end.
A few other aspects of a scaled-down agreement are less clear:
- A debt limit increase looks likely to be omitted from a scaled back agreement. The President did not include a debt limit increase in the scaled-down approach to the fiscal cliff he announced on Dec. 21, nor in the proposal reported today.
- It is unclear whether such a deal will fully address the sequester. It is possible that a compromise could delay the sequester for a short period (i.e., 60 or 90 days), or that it could delay only part of the spending cuts that are scheduled to take effect (i.e., only the defense portion). It is possible, but less likely, that a last-minute agreement could simply not address the sequester at all, leaving the issue to be dealt with in early 2013.
Q: If there is no deal by year end, does it matter?
A: Yes, but how much will depend on how uncertain the outcome remains, and how long the uncertainty lasts. In our view it seems more likely that Congress will miss the year-end deadline but will pass an agreement in January. In theory this could come as early as January 2, the last day before Congress convenes for its new session, but it seems more likely to occur between January 3 (the first day of the new session and the scheduled date for congressional leadership elections) and January 21, when the President will be inaugurated into his second term (Exhibit 1 lists key fiscal policy events over the coming months).
The effect of a temporary lapse would come mainly through confidence. We have noted recently that policy uncertainty might hold back capital spending. The risks associated with the fiscal cliff also seem likely to have already weighed on consumer confidence to some extent, even before the deadline. Consumers’ assessment of the current situation has become quite positive at the same time that their expectations for the future have become more pessimistic (Exhibit 2). This is likely due in part to reduced expectations of a deal by year-end; indeed, internet searches for the term “fiscal cliff” have outpaced searches related to the debt ceiling at the comparable period in 2011. (Exhibit 3). However, from a fundamental perspective, the effect of a short lapse would probably not be that significant, assuming that it lasted no more than a few weeks. This would be especially true if there is some certainty regarding the eventual outcome, and an expectation that the eventual agreement will be made retroactive (which we expect it would be).
Q: Is there anything that can be done to avoid the increase in tax withholding and decrease in spending set to take effect that doesn’t involve Congressional approval?
A: The administration can prevent some of the tax increase and sequester, but only for a while. The Internal Revenue Service (IRS) must decide how to instruct employers and payroll processors to withhold taxes from paychecks starting January 1. Normally the IRS transmits updated withholding information by early December to allow sufficient time for systems adjustments. While the IRS has indicated it will provide guidance by year end on appropriate withholding for 2013, to date it has not provided an update. While some larger payroll processing firms and employers may be able to adjust systems very quickly in
response to a last-minute deal, smaller firms may not be able to adjust as quickly.
The IRS also has discretion in how much to instruct employers to withhold. Although only Congress determines the ultimate tax liabilities individuals will face for 2013, the IRS must instruct employers on how to best withhold taxes from paychecks to match those rates. In principle, the IRS could simply instruct employers to leave withholding unchanged until an agreement is sorted out, at which point new withholding instructions could be transmitted. This is an obvious short-term solution, but it could only be used for a few weeks. If the IRS declined to update withholding instructions much longer than that, individuals could face a more serious gap between their withheld taxes and ultimate tax liabilities, resulting in significant tax liabilities at year end, or an even sharper increase in tax withholding once instructions to employers were eventually updated.
On the spending side, the administration can delay the spending cuts scheduled to take effect under sequestration if a deal seems close at hand.1 However, just like a delay in the scheduled tax increase, failure to implement the cut at year end might mean an even sharper adjustment later if Congress is unable to reach an eventual agreement, since the required reduction would need to be concentrated in a shorter period (i.e., the remainder of the fiscal year that ends September 30, 2013).
Q: The debt limit will be reached December 31?how does this relate to the “fiscal cliff”?
A: The debt limit is separate from the fiscal cliff, but intertwined in the negotiations. The Treasury projects that the debt limit will be reached December 31, but that it will be able to tap certain funds that will allow it to continue to borrow as necessary until late February 2013, by which point Congress will need to increase the limit. The Treasury notes that if the fiscal cliff is left unresolved, the deadline for the next increase in the debt limit would be pushed beyond late February, though it does not specify how far beyond. Exhibit 4 shows our projection of debt subject to limit under our base case fiscal assumptions and a scenario in which the fiscal cliff is not resolved.
The White House very much wants to avoid another disruptive debate over the debt limit similar to the one that occurred in the summer of 2011. The Administration had hoped to include a debt limit increase in the year-end agreement, first proposing an open-ended increase, and later seeking a two-year extension. However, congressional Republicans continue to insist on a dollar of spending cuts (measured over ten years) for each dollar the debt limit is increased. At this point it appears more likely that the debt limit increase will be left out of a year-end deal, as will any long-term spending reforms. Instead, these look likely to be debated in a second round of negotiations ahead of the next deadline, probably in February 2013.
Q: What should we expect from the rating agencies?
A: Probably no action as a result of the fiscal cliff, but a downgrade in 2013 is possible. Two of the three major rating agencies, Standard & Poor’s and Moody’s Investor Service, have indicated they are unlikely to lower their rating regardless of how the fiscal cliff is resolved. While both acknowledge that a sharp fiscal contraction would lead to economic uncertainty and a likely recession, the contraction would also probably be enough to stabilize and slightly lower the debt-to-GDP ratio over the medium term, which is the most important criterion for the sovereign rating. By contrast, Fitch Ratings, which maintained a stable outlook on its AAA rating longer than the others (it shifted to a negative outlook only after the “super committee” failed to reach an agreement in late 2011) has become more downbeat, suggesting a downgrade is possible if the debt limit is not raised in a timely manner or if the fiscal cliff is allowed to take effect for long enough to have significant economic effects.