Macro Wrap – Hard to Put the Toothpaste Back in the Tube

by Enis December 31, 2012 7:38 am • Commentary

I’m pumped to be back at my desk writing again after a one-week restful break.  Though I haven’t been writing, I’ve been closely following the developments in the market, particularly because of the price action in the VIX.  We have seen very rare price action in the volatility market in the past 2 weeks, with the VIX making one of its biggest moves of the year despite the arrival of the holiday season.  The setup of high implied volatility and a highly anticipated news event makes for an interesting start to 2013.

At this juncture, I don’t put much weight on whether a deal is reached today or not.  Far more important in my mind will be the roadmap that is laid out for the more far-reaching negotiations in 2013.  To illustrate my point, I anticipate 2 main potential scenarios over the next week:

  1. A short-term deal is reached to avert the fiscal cliff.  This deal will likely prevent the tax increases on the majority of Americans and push back the longer-term negotiations to be resolved as part of the debt ceiling debate in the spring.
  2. We initially go over the cliff, but the new Congress quickly passes retroactive tax cuts that avert the majority of the impact from going over the cliff.  The major long-term negotiations are still unresolved, and again pushed back to the debt ceiling debate in the spring.

In both cases, the real long-term budget issues will be unresolved, forcing another budget fight in February or March.  The practical implications of either scenario will be essentially identical.  I place a much lower probability on either a grand bargain deal in the next week (the positive market scenario), or a situation where we go over the cliff, and no retroactive action is taken by the new Congress (the negative market scenario).

As the deadline has approached, I think the market has started to anticipate that the most likely scenario is a short-term fix as I outlined above.  However, that short-term fix is not necessarily a positive, as it likely implies that the market has deal with another wrenching negotiation process in only a few months.  From my perch, that’s the main reason for the market leaking lower in the past week.  One way or another, the “fiscal cliff” uncertainty has not been resolved.

One final point.  Of the 2 potential scenarios I outlined above, I think 1) is more positive than 2) for the market.  Though the outcomes sound similar, I anticipate more difficulty in getting Congress to agree on the details of any retroactive tax cut deal amenable to both sides (just like they have had difficulty on any current deal).  In other words, it’s harder to change the status quo than to maintain it, or as the village elder would say, “it’s hard to put the toothpaste back into the tube.”  In that case, going over the fiscal cliff might not be as benign as it seems.  The VIX continuing to rise with each passing day of no deal seems to agree.

Happy New Year