Committee for a Responsible Federal Budget

MARKETWATCH: December 13– December 16, 2010

Dec 16, 2010 | Economics| Taxes

Nearing the end of the week, markets are still wrestling with the same cross-currents they faced last week, but with a new wrinkle - Spain.

The growth play: With most forecasters sticking to their stronger near-term growth forecasts since the tax cut deal was announced, traders have continued to rebalance portfolios away from bonds and into stocks. Still, growth is not expected to be strong and data has continued to be mixed.

The risk play: Demand for U.S. Treasury bonds has continued to be affected by yo-yo safe haven effects tied to the ebb and flow of confidence in the eurozone’s ability to manage its fiscal woes. In the past week, safe haven demand for Treasuries eased as markets seemed reassured that Ireland was getting its fiscal and financial troubles under control with the support of the IMF-EU rescue package and the ECB. However, new news about Spanish bank weaknesses could bring back the safe haven story.

With the growth play dominating, mortgage rates on 30-year bonds had climbed to just below 5 percent by early afternoon Thursday, their highest point since May and up from record lows in November (closer to 4 percent). Trends have been similar for the benchmark 10-year note. However, interest rates have since reversed course and headed down a little as investors looking for return increased purchases of Treasuries at what were considered attractive (higher) yields.

For the longer term, the prospect of U.S. fiscal deterioration (even worse if the tax cut deal goes through) continues to hang over financial markets, although so far they have digested it in their stride. With no fiscal offset proposed in the medium-run for the tax cut package deal and little evidence that one will be agreed in the near future, the credit ratings agency Moody's warned several days ago that it may downgrade the Aaa rating of U.S. sovereign debt if the rising debt trend continued unchecked over the next few years. In an interview today, the head of the International Monetary Fund (IMF) called the tax cut deal positive on balance for near-term growth and noted the importance of supporting growth now for the US - as well as for the rest of the world. He however also warned that over the medium run, the U.S. will need to cut its deficit through a fiscal consolidation plan. In that regard, he noted, the recent Fiscal (Bowles-Simpson) Commission recommendations “make sense”.