MuniLand

Want to scare yourself a little? Bill Gross, who runs one of the world’s largest bond mutual funds, says that U.S. Treasuries are losing their status as the top global asset. Bloomberg has the story (emphasis mine):

Gross wrote in his monthly investment commentary last week that the U.S. will no longer be the first destination of global capital in search of safe returns unless fiscal spending and debt growth slows, saying the nation “frequently pleasures itself with budgetary crystal meth.”

Gross can turn a phrase, but the ability of the U.S. Treasury to endlessly issue bonds to fund the national deficit actually relies on the strong demand for U.S. debt from global investors. If and when the demand drops, it will make issuing debt more expensive (even if the Federal Reserve switches from buying mortgage backed securities under QE3 to buying U.S. Treasuries). Interest rates and the federal cost of debt service will rise. It is not a pretty picture.

Our “budgetary crystal meth”, as Gross terms it, is the government’s ability to issue debt to cover our fiscal deficits. Issuing debt is a short-term fix that keeps the system functioning without bringing the federal budget into balance. It allows us to push our fiscal problems down the road.

Looming at the start of 2013 is the “fiscal cliff,” when a series of tax increases and mandated spending cuts are scheduled to take $800 billion out of the economy (approximately 5% of 2012 GDP). Some argue that we can rescind these changes because we can issue debt to cover the federal deficit – and there is plenty of demand for U.S. Treasuries – which would postpone a contraction in the economy.

Blackrock has published a piece, 2012 Elections: Implications, Insights and Investment, that includes the chart above, detailing the components of the “fiscal cliff”. This is the menu of tax increases and spending cuts that members of Congress will be arguing over following the election. Blackrock’s analysis suggests that the country will not go over the fiscal cliff:

Financial markets, however, are not really pricing in a high probability that the fiscal cliff will occur. The consensus expectation among economists is that the United States will grow by around 2% next year, and analyst expectations for corporate earnings are still quite good for 2013. Additionally, the significant run-up in stock prices we have seen recently, combined with surprisingly low volatility, certainly runs counter to what we might expect if investors were dreading the fiscal cliff. In sum, it appears markets are expecting most provisions of the cliff to be postponed or watered down at the 11th hour—similar to what happened with last summer’s debt ceiling debate.

This fight over the looming tax increases and spending cuts will dwarf the debt ceiling fight of last summer. As many competing forces push their interests, the uncertainty is enormous. What will prevail: more “budgetary crystal meth,” or the tough choices of the fiscal cliff?