Macro Wrap – Was the Congressional Budget Deal Bad News for Stocks?

by Enis December 12, 2013 6:30 am • Commentary

Yesterday’s 1%+ down day in the SPX was the first in more than a month, and only the 5th such day since July 1st.  The VIX closed at its highest level since mid-October, despite the upcoming holiday season.  And all of the selling came on a day when Congress finally came to some sort of agreement without the threat of a “catastrophic” deadline.

In markets, as in politics, anticipating the unintended consequences is how many butter their bread.  First, a quick recap of the political backdrop that led to the deal:

  1. Republicans got slammed in the polls after the government shutdown, so there was an obvious incentive avoid a repeat in the Jan/Feb time frame, closer to the 2014 elections.
  2. Obamacare’s failures has become the focus of headlines in Washington, and Republicans do not want another budget fight / potential shutdown to steal those headlines
  3. Democrats were able to reduce some of the sequestration cuts as a result of the Republicans’ willingness to negotiate given points 1 and 2 above
  4. A small agreement over the budget now paves the way for an easier negotiation over the debt ceiling in early 2014.  Both sides seem more interested in preparing for the midterm elections than digging their heels in now.

In short, Congress has much less incentive to fight today compared to the past year.  Why might that actually be bad news for stocks?

The Federal Reserve has repeatedly cited fiscal tightening and political gridlock as reasons for continuing QE at its current pace.  Current and former economic advisors (Bernanke, Romer, Summers, etc.) to the administration have pointed out the risks of a 1937 scenario in the U.S., when policymakers attempted to tighten policy after a few years of recovery, only to witness a rapid return to stagnation.  The Fed has been wary of repeating such a scenario, for better or for worse.

With yesterday’s budget deal, fiscal policy has loosened a bit, and perhaps more importantly, overall political perceptions have improved.  Many traders had marked the March FOMC meeting as the earliest potential date for a Fed tapering after the September meeting yielded no change in policy.  December would be right before the holidays, and January would be right before the next budget battle.  Well, yesterday’s news potentially puts January back on the table for a tapering decision, especially after Friday’s jobs report printed a 7.0% unemployment reading, the level that Bernanke cited at the start of 2013 for when QE might be over.

With the FOMC meeting looming on Wednesday, traders are starting to think that perhaps, just perhaps, we’ll see the Fed put in language that targets a January taper.  Remember the market reaction in June when Bernanke suggested a potential taper in 2H 2013 (almost 100 SPX points lower in 3 days).  While a December taper remains unlikely, a signal that the taper is likely in late January could cause indigestion as well.

2013 has been a year of head fakes on the downside.  Yesterday’s price action might simply be another head fake.  But the fiscal and economic backdrop has become much more conducive to a Fed taper compared to 3 months ago.  With bullish sentiment near extremes, I see greater risk of coal in the stockings rather than a Santa Claus rally in the coming weeks.