By Alice Leedale
The US managed to avoid “going over” the fiscal cliff; however, the last-minute deal postponed most of the difficult fiscal decisions. While some tax increases will come into force, the automatic spending cuts have merely been pushed back by two months. The debt ceiling needs to be raised by February/March. Once again, it is likely that the decision will be left to the eleventh hour. Worries may take a few weeks to surface but we haven’t forgotten what happened during the last debt ceiling fiasco in summer 2011.
The FOMC surprised markets with the minutes of the last meeting hinting at the possibility of tightening much earlier than expected; however, “concerns about financial stability” were the primary reason rather than an improved view of the US economy. The news was enough to break 10y US Treasuries out of the 1.6-1.8% range they have been in since August, up to 1.9%. Whether treasuries quickly return to this trading range or not is key. While the front end of the curve should remain pinned down for now by the Fed’s guidance on rate hikes, any slowing of asset purchases will see a steepening of the curve.
The US dollar strengthened against most currencies, including the euro, as the prospect of tighter monetary policy had the “traditional” effect on the currency, rather than the “risk on” move that would have seen the euro and US dollar rise. Could this be the end of “risk on”/”risk off” and a return to fundamentals?
A combination of improved risk sentiment and beginning-of-year optimism means January could be a bad month for US Treasuries. After that, the market may start to worry about the US fiscal situation again, however the outlook for bonds is ambiguous. The typical “risk off” move into treasuries could be tempered by the fact that spending cuts have yet to be agreed upon, which is likely to act as a negative for bonds due to the implications for the size of the deficit. This week brought a data lull following non-farm payrolls last Friday which was in line with expectations at +155k; however, since the Fed’s decision to link monetary policy more explicitly to employment, focus has shifted to the unemployment rate.
Alice Leedale is market strategist, RWC’s Absolute Return Bond and Currency Team
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