A Few Observations about the US Deficit Deal

The deal that has been struck by party leaders in the US now needs rank and file support.  Some modifications even at this late date are possible, but there are several points that are worth considering at this juncture.  

First, even though the US has technically defaulted in the past (a similar episode as now took place in the late 1970s) a significant default never seemed like the most likely scenario and now this seems even more remote.

Second, a downgrade of the US is not imminent.  My best guess is that if S&P does downgrade the US it would be after the fiscal commission issues their report later this year.  If S&P does downgrade the US, and there does seem to be some confusion about the S&P indication that  $4 trillion deficit reduction was required to to hold off a downgrade, the market impact may be quite marginal.  Many holders of US Treasuries believe they have little choice, from central banks to corporate treasuries and pension funds.  In addition, if S&P is alone it the downgrade, it also seems somewhat less important, though of course a threshold would be violated.  

Third, debt stabilization remains elusive.   It is similar to what has happened in Europe over Greece.  A new package has been agreed to by the elites--still to be ratified and some modifications possible--but Greece's debt to GDP will still be twice the level that is mandated by the Maastricht Treaty and the Stability and Growth Pact.   Just like a Greece 3.0 will be needed, so too does the US plan fall short of what is ultimately needed to put US fiscal policy on a sustainable trajectory.   Perhaps this is what the 2012 elections will ultimately be about.  

Fourth, the debt deal, which does not include extending this year's stimulus measures, means the fiscal drag on the US economy will be a bit larger next year than previously anticipated.   Given the CBO assessment, economists are likely to estimate that drag at 1.25%-1.50%.  This coupled with what we learned last week, that the US economy all but stagnated in Q1 and while Q2 looked better, it is subject to such substantial statistical revision to make the advanced estimate nearly irrelevant , the possibility of QE3 will begin to be reconsidered by investors.  With the risk of deflation non-existent at this point, and money supply beginning to accelerate, the bar is still high.  That said, a negative jobs report--that is an outright loss of jobs--would likely see the talk gain wider currency.   Next week's FOMC statement will be scrutinized for insight into these prospects.  
A Few Observations about the US Deficit Deal A Few Observations about the US Deficit Deal Reviewed by Marc Chandler on August 01, 2011 Rating: 5
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