One of the expressions to come out of the GFC (global financial crisis) is “kicking the can down the road”.  This refers to politicians who delay or defer rather than taking strong action to reduce debt.  

What we saw out of the US over the last few days was classic “kicking the can”.  Rather than take hard decisions on spending cuts the focus of the fiscal cliff compromise was on increasing taxes in the most painless way possible.   

The reaction of US related markets to all this was interesting with the US sharemarket rallying and the US bond market and dollar selling off.  The sharemarket rally is intriguing as the US fiscal/debt issue has not been resolved at all.  Instead it has been delayed again with the next stage in this saga coming in February when the US debt ceiling of US$16.4 trillion will need to be debated by Congress. 

For now the sharemarket is possibly signaling it believes that the “can” could be kicked down the road indefinitely.  But is this case or will something bring this to an abrupt end?  Some scenarios that could finally bring this to a head include: 

–          The debt ceiling debate by Congress in February; will the Republicans finally decide to not compromise on the need for spending cuts?  

–          The reaction of credit rating agencies.  Standard & Poor’s has already down graded the US one notch to AA+ back in August 2011, with a negative watch.  The fiscal cliff outcome increases the likelihood of another downgrade some time in 2013. 

–          US bond holders voting with their feet and selling US treasuries, although this is currently being countered by the US Federal Reserve continuing to buy US bonds. 

Some combination of these factors could bring the “can kicking” to an abrupt end but there is also the possibility that like Japan, the markets allow the US the latitude to continue to increase its debt.  This is possibly manageable for an extended period as the Japanese experience shows, although that has come at the cost of low growth in Japan for the past two decades.  

Probably the scenario to watch for most is a material increase in US interest rates occurring, either through inflation resurfacing and/or a significant increase in the risk premium on US debt.  While this may not occur any time soon these factors will need to be monitored closely in 2013 (and possibly beyond) given their potential to bring the US debt situation to a painful end.

Anthony Quirk

Managing Director