Fiscal Cliff and Markets: How Looming Crisis is Affecting Stocks, Bonds, and Commodities

The fiscal cliff and debt ceiling crises bring considerable uncertainty to stock, commodity and bond markets. With the fiscal cliff just days away and the debt ceiling quickly approaching, it is important to understand how these events will affect stocks and bonds in 2013.

Stocks and Commodities

Barring congressional compromise, January 2nd’s fiscal cliff will bring $109 billion in automatic spending cuts along with $536 billion in tax increases. This means that $645 billion that would usually land in the hands of business owners via-rent, groceries or other expenditures will no longer be available.

With less money in the markets, a temporary drop in stock and commodity prices is certain, but the exact impact on the markets is hard to predict. Our inability to forecast is worsened as the debt limit approaches — something that is sure to be reached by February if not sooner.

The uncertainty that comes with the fiscal cliff and debt ceiling increases risk in stock ownership. This increased risk in stock ownership means that stocks will be sold and thus, the stock market will fall. As we see today, fear of the fiscal cliff lowers the markets more than great economic news raises them, meaning that come January 2, $645 billion in fiscal cliff losses are sure to outweigh any positive Q1 economic performance.

The last time we approached the debt ceiling, the S&P 500 index dropped more than 16%. Some say that this drop was due to our credit downgrade, but most stock losses came before the downgrade on August 5, 2011. Even without a credit downgrade, a 16% drop is again possible. This drop could be increased due to the $645 billion that is sure to be lost because of the fiscal cliff. Commodities have been following stock prices lower in recent weeks, and we can expect that trend to continue in 2013. The fiscal cliff and the debt ceiling certainly give both stock and commodity markets reason to worry.

U.S. Treasury Bonds

The fiscal cliff makes U.S. Treasury bonds more appealing because stocks are likely to drop whereas bonds will continue to provide income in the form of interest payments. With the Federal Reserve agreeing to keep interest rates low until unemployment falls to 6.5% or inflation rises to 2.5%, and with quantitative easing still in effect, a selloff in U.S. treasuries is unlikely. Low inflation rates make bonds more attractive because they allow bonds to do well even when our currency is devalued. When looking only at the fiscal cliff, U.S. bonds seem to be among the safest investments.

But the debt ceiling threatens bond yields just as it did in August 2011. If the government reaches the debt limit and compromise on decreasing the deficit proves impossible, the U.S. Treasury will be forced to default on some bond payments. Thus, until the debt ceiling is raised (or until government debt is decreased), bonds will continue to carry significant risk.

Even with the fiscal cliff aiding bond yields, the debt ceiling crisis looks to be damaging. If our credit rating is downgraded once again, yields will sink even further and interest rates on government debt will increase. Until the debt ceiling issue is resolved, either through raising the debt ceiling or by decreasing debt, bond yields are likely to decline.

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If our leaders in Congress can find a way to compromise on the fiscal cliff and debt ceiling, much uncertainty would be removed from the market. This would lead to decreased risk and greater profits for investors of stocks, commodities, and bonds alike.