Fiscal Cliff Overshadows Positive Economic News

Last Tuesday, improvements were announced in consumer confidence, housing prices and orders for equipment and machinery. Coupled with early reports of strong holiday shopping figures, this is the kind of news that would normally send stocks soaring. Instead, the Dow Jones Industrial Average lost 89 points.

What gives?

Simply enough, the shadow of the fiscal cliff is looming over everything. There have been no signs of progress on a budget deal, and when it comes to trying to beat an impending deadline, no news is bad news.

What the fiscal cliff means to the markets

There are two observations to make about the way the financial markets are acting against the backdrop of this drama:

1. The stock market is holding the government's feet to the fire. Investors know that if the fiscal cliff measures of higher taxes and steep spending cuts go into effect, economic conditions will be sharply different come January. That's why the market shrugged off the apparent good news on consumer confidence, housing and orders for equipment and machinery. Without a budget deal, all those indicators could very quickly turn sour in the months to come. Markets are not always rational, but they do tend to anticipate events. Right now the message is that they won't be mollified by anything short of a credible budget solution.
2. Things are much calmer on the bond side of things. Meanwhile, things are much calmer in the bond market. Yields on U.S. government bonds have drifted slightly lower during November, which means prices are up a bit. The bond market, you see, has less to fear from the fiscal cliff. Deficit-reducing measures, however drastic, would improve the reliability of government bonds. If the economy is brought to a standstill, it would probably choke off inflation, which is also good for bonds. What message can consumers take from this? Well, the bond market is signalling that going over the fiscal cliff would probably mean rates on savings accounts and money market accounts would remain near zero. Mortgage rates could actually move a little lower, though current mortgage rates are probably close to as low as they can go. The rub for potential mortgage customers would be that a weakened economy would likely mean very tight lending standards.

There are times when the stock market can just seem contrary -- good news is treated as bad news or vice versa. This is generally because of expectations, meaning the market has either over-anticipated an announcement or is hoping conditions will prompt a reaction from a government agency, such as the Fed.

With regard to the fiscal cliff, though, the market seems to be playing it straight. It's not that it is acting contrary toward other economic news -- it is just ignoring it. The question is, can Washington ignore a distressed stock market?

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