Despite the hope of the last day or two, policymakers remain, we suggest, as far apart as they ever have, with 'no news' simply that. An oversold bounce does not a fiscal cliff fix, and as BofAML's Michael Hanson suggests in his 'brief history of brinksmanship': "one lesson from the recent past is that market reaction has been an important mechanism to reaching compromise and forcing action." Unfortunately, he adds, as we have been quite vociferous about, that "history also shows that the equity markets have to sell off sharply before policy makers listen to the 'stock market vigilantes'." With some politicians still thinking going over the cliff might be their best strategy, it could once again take a sharp market sell-off to focus the minds of the negotiating parties. If we actually manage to go over the cliff, even if only for a brief period of time, a repeat of the TARP sell-off seems only too probable.
Via BofAML: A brief history of brinkmanship by Michael S. Hanson
Policymakers have recently made a habit of creating deadlines, thresholds and cliffs to force themselves to act. The result has often been severe market volatility around key decision dates. Markets may be in for yet another bumpy ride as US fiscal cliff and European sovereign debt negotiations continue. However, one lesson from the recent past is that market reaction has been an important mechanism to reaching compromise and forcing action. Unfortunately, history also shows that the equity markets have to sell off sharply before policy makers listen to the “stock market vigilantes.”
The fiscal cliff is the latest example of a brinkmanship moment — and a large one to boot. Japan just recently averted its own fiscal cliff scenario, and several budgetary challenges loom for peripheral European countries. Politicians appear to have learned from past episodes that these deadlines are useful negotiating tools. But a review of recent history suggests it is less the deadlines themselves than the negative market reaction as the deadline approaches — or goes whistling past without action — that actually forces some resolution.
Toss a damp TARP on it
The debate over TARP (the Troubled Asset Relief Program) is perhaps the canonical example of a brinkmanship moment where the market forced action. Treasury Secretary Henry Paulson formally proposed the TARP on 21 September 2008, and the markets started to rally a few days earlier on the news of the bailout plan. A contentious battle with Congress followed, as the Senate Banking Committee rejected the plan on 23 September. The House and Senate then worked to fasten a compromise, but that was rejected by the House on 29 September by a 205-228 vote, largely along party lines. The S&P 500 fell 8.8% on that day alone. TARP was finally passed after the third try on 3 October, but the damage was done. Markets continued to drop sharply over the next week, ultimately dropping more than 28% from when the news of TARP first leaked out. Equity markets sold off sharply in Asia and Europe as well.
Rolling European risks
Similarly, the sovereign and banking crises in Europe have resulted in a number of market sell-offs and spikes in volatility (Chart 1). In May 2010, market volatility again mounted as uncertainty preceded the adoption of the first bailout plan for Greece — the first of several. Additional market sell-offs occurred around other European policy debates, including setting up support programs for other peripheral countries and the establishment of the EFSF and ESM. Despite various actions by the ECB that soothed the markets (rate cuts, LTROs, OTM), the risk of additional brinkmanship in 2013 remains, as northern bailout fatigue meets up against southern reform resistance.
The debt limit debacle
TARP was the first scene in the multi-act tragedy that has been US fiscal policy over the past several years. Passing “continuing resolutions” at the last minute that avert a government shutdown, but only keep the federal government running temporarily has become the norm. In mid-2011, US politicians went to the brink over the debt limit, as conservative House Republicans toyed with the possibility of a default on US Treasury debt to get President Obama and Senate Democrats to accede to significant spending cuts. Again, the markets sold off sharply, helping cement the Budget Control Act of 2011. This act included the now infamous “Supercommittee,” charged with agreeing to a comprehensive, long-term deficit reduction plan. Instead, they agreed to disagree and fell into another threat point that was never meant to happen: the US$1.2tn automatic spending cuts known as the sequester. The markets again sold off in late November 2011 on that news. Other measures of uncertainty spiked as well (Chart 2), and have generally remained high.
Clambering along the US fiscal cliff
In all of these cases the market reaction — or threat thereof — helped to motivate policy makers to step back from the brink and find a solution. The same is likely the case, in our view, for the ongoing fiscal cliff negotiations — itself a construct of delays and manufactured deadlines. Once it became clear that the US election would largely return the status quo to power — the same folks who built the cliff — the markets sold off as they reassessed the risks around the cliff (Chart 3).
This past Friday, a meeting at the White House to start the cliff negotiations concluded cordially, pushing up market optimism. However, no policy decisions were reached, and news reports suggested that the two sides largely agreed to disagree for now on several key points, such as how to raise additional revenue as part of any deal. There is limited time to put together anything more than a down-payment on a bigger deal that will have to be negotiated further — and likely will have its own deadlines and triggers should an agreement remain out of reach.
Meanwhile, the recent market reaction demonstrates the risk of additional volatility as investors grow optimistic when “good news” on the cliff is announced. When talks stumble at a difficult stage of the negotiations, which seems inevitable given the distance that remains between the two sides, markets may again sell off. Moreover, every time the market reacts positively to even the lightest of positive news, the pressure on policy makers to reach a conclusion relaxes. With some politicians still thinking going over the cliff might be their best strategy, it could once again take a sharp market sell-off to focus the minds of the negotiating parties. If we actually manage to go over the cliff, even if only for a brief period of time, a repeat of the TARP sell-off seems only too probable.