iShares : A Bond’s-Eye View of the Fiscal Cliff

ETF Trends

Uncertainty reigns in the fixed income market, and, surprisingly, it has little to do with the direction of interest rates.

The Fed, with its third round of quantitative easing, has telegraphed its intention to keep short-term interest rates near zero through mid-2015. At the same time, the QE programs that have been put in place are keeping longer term rates down as well. The current challenge for markets is less about Fed policy and more about politics: The looming fiscal cliff.

Russ has warned that there’s a better than a 50/50 chance that the nation goes over the fiscal cliff, meaning a combination of tax hikes and spending cuts would go into effect come January 1 that could crimp US GDP by 4% or more next year.

So, what’s a bond investor to do? I’ve already talked about flows we’re seeing into municipal bond ETFs as investors prepare ahead of the cliff.  But a recent paper from the BlackRock Investment Institute looks at three possible fiscal cliff outcomes – the sky dive, the bungee jump and the hard stop. I’d like to address those scenarios and their potential impact on fixed income markets.

1.)  A hard stop . This scenario means the United States sees a last-minute deal, with lawmakers extending most programs in return for some spending cuts. Lawmakers would then work toward a comprehensive budget deal in mid-2013. In this scenario, if there are signs that a real budget deal is in the works, we would likely see little impact on the fixed income market, as this appears to be what many investors in the market currently expect. But if the deal is seen as another Band-Aid, risk assets could sell off as investors become concerned about future disruptions arising from political gridlock. Of the three, this scenario would likely be the least disruptive for markets in the short term, and high quality segments of the fixed income market — like investment grade corporates and municipals — would likely continue to fare well.

2.)  Bungee jump . In this outcome, we are faced with a Republican sweep of the presidency, House and Senate. While there is no deal in the lame-duck session, lawmakers announce a plan to reverse tax increases in January and the debt ceiling would be raised ahead of a full budget deal. In this case, we’d likely see market volatility during December and January until a new plan is put in place.  As per the previous scenario the net impact on markets is likely to be muted, though this is highly dependent upon the final budget, tax and spending measures put in place. The wildcard here is the ability of the new government to implement real structural reforms; failure to do so would likely result in a sell-off of risky assets and outperformance from higher quality investments like Treasuries.

3.)  Sky dive . In this final scenario, Obama wins the election and Washington remains partisan and divided. In this scenario we could sky dive off the cliff. While there is a possible income tax deal in early January, prepare for politicians to wrangle over the debt ceiling. This scenario would cause anxiety throughout the end of the year and into 2013, and the Fed might be required to step in to continue supporting the economy and markets. For fixed income investors, this scenario would likely result in continued low interest rates and sluggish growth. Longer duration investments could excel, along with any segment of the market that the Fed stepped in to purchase. Higher risk asset classes would likely under-perform, and investors looking for yield would likely be better served in lower risk investments such as investment grade debt and municipal bonds

No matter what happens with the fiscal cliff, we are likely to see relatively low interest rates over the near term. Investors looking to increase yield by moving into credit and other higher risk segments of the bond market should think about the cliff and its potential impact on their portfolio.  But no matter which outcome you think is most likely, remember to vote.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.

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