Geronimo Redux or: How I Learned to Stop Worrying and Love the Fiscal Cliff

Dec 4, 2012

With less than a month to go before the end of the year, there is still no deal to be reached to avoid the fiscal cliff, a $540 billion combination of automatic tax hikes and spending cuts set to kick in at year’s end.

A couple months ago I wrote a column on the fiscal cliff (Geronimo!, JLN Forex, August 21, 2012) in which I laid out the argument for simply taking a swan dive off the cliff, accepting the inevitable pain, and then get to work rebuilding the economy from scratch. Needless to say, my advice has not been heeded, nor is it expected to anytime soon, since it requires both bold action and honesty, two traits that are sorely lacking in Washington these days.

Since the publication of that column, I have been patiently biding my time, waiting for a “deal” to be reached so that I may blast it for kicking the can down the road by offering short-term window-dressing, while promising to make hard choices and steep cuts after the next election cycle.

On Monday afternoon, Republican leaders in Congress submitted their counter-offer to President Obama’s previous offer. We now have fuzzy math and vague promises from the GOP, in a bill that the President won’t sign, to counter the fuzzy math and vague promises from the left, in a budget that would not have passed the House.

Both sides use as a scare tactic the Congressional Budget Office study on the fiscal cliff, which was released on November 8, 2012. The study claims that, if no deal is reached, in 2013 the U.S. will enter a recession, unemployment will increase to 9.1 percent, and economic growth will be nonexistent. Growth rates vary under different scenarios, but if all tax cuts were extended and all spending cuts canceled, the economy would grow by three percent which, in a $15 trillion economy, would be $450 billion.

In other words, strip away the language, finger pointing and bloviation and the argument we are left with is that, under the best case scenario, avoiding the fiscal cliff entirely, and adding the $540 billion back into the budget deficit will lead to economic growth of $450 billion. In fact, under each scenario laid out in the CBO study, the economy grows by less than a dollar for each dollar added to the deficit.

With the current political environment, and our current crop of gutless leaders, can-kicking is a foregone conclusion. From a forex trader’s perspective, though, the structure of any deal will have implications on the direction of the dollar.

Suppose, for example, a deal is reached that holds the line on tax hikes and spending cuts today, but promises to phase in changes over the next 10-20 years. It will look like bold action, but really it will become someone else’s problem – an even larger fiscal cliff to be avoided by the next generation of political leaders. Such a deal, while horrifically bad for the long-term, would be “risk-on” today. Sell the dollar for riskier assets, such as Brazil (USD/BRZ), India (USD/INR), gold, grains, and so on.

Suppose instead we agree to take some of the pain now, by imposing a tax hike and/or making some real cuts in spending (as opposed to accounting gimmicks that pretend to be cuts). Taking  pain means deflation. Deflation means buying dollars and selling risky assets, a la 2008-09.

The third scenario would be a mixture of the first two – a bit of window-dressing, but with a new cliff built in 6-12 months down the road. Under this scenario, the markets would remain frozen in place. For a clue on which scenario the market is predicting, see the OptionWorks volatility table in today’s newsletter. Old-timers among us remember a period or two with levels this low, but, to me, these prices are amazing given the looming uncertainty.

In the end, we will not be out of the woods until we have a full writedown of the excesses from the credit boom. I still believe that a dive off the cliff would be a logical path toward progress, if it were done with full transparency and shared sacrifice. But that will not happen until the bond market forces the hand of these feeble leaders. In the meantime, the least we can do is spot the dollar’s direction and ride what little price action we see.

Stop worrying and love the fiscal cliff.

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