As Washington frets, markets take spending cuts in stride

Broad spending cuts designed to slam most U.S. government programs with all the subtlety of a sledgehammer were set to begin taking effect on Friday, yet investors have so far barely batted an eyelash.

The $85 billion in across-the-board "sequestration" cuts were expected to cause airport delays, disrupt public services and result in lower pay or layoffs for millions of government workers.

What they were not likely to do, at least as far as financial markets were concerned, was cause enough damage to derail a U.S. economy that has lately been gaining momentum.

The prospect of weaker growth and a jump in unemployment caused by the cuts was also being seen by some in the markets as making it more likely the U.S. Federal Reserve will need to maintain its ultra lose monetary policy for longer.

"The market is of the view that if there's a fiscal tightening which causes a significant negative impact on economic prospects and the labor market, then the Fed will have to respond," said Ian Stannard, head of European FX strategy at Morgan Stanley.

Financial markets have also had a long time to assess the potential impact of the cuts on growth and believe it is not tantamount to a recession trigger.

"There is no immediate and visible impact to the economy so markets are not seeing it as a tail risk," said Ayako Sera, a market economist at Sumitomo Mitsui Trust Bank in Tokyo.

"It's not that money will stop circulating, unlike in the case of a debt ceiling where necessary government payments due will be suspended. So maybe time is needed for markets to digest the significance of the news, prompting investors to stay to the sidelines," she said.

Share markets in Europe were lower on Friday ahead of the budget cuts but this was linked to data pointing to weaker growth in Europe and China as well as residual concern about the inconclusive Italian election.

The MSCI world equity index was down about 0.3 percent on Friday, while the dollar had gained about 0.2 percent against a basket of currencies, its highest level in nearly six months.

However, the growth implications of the spending cuts for the world's biggest oil consumer did send crude prices lower.

U.S. oil fell about $1 a barrel to $91 while Brent crude touched a low of $110.06 in European trade, its weakest price since Jan. 17.

Stock index futures pointed to a mixed open on Wall Street when trading resumes on Friday where the benchmark Dow Jones industrial average is just 1 percent below a record high, having gained more than 7 percent this year. The more widely followed Standard & Poor's 500 is less than 4 percent from entering record territory.

Even an index of stocks in a sector seen at the cross-hairs of the cuts, the Philadelphia Stock Exchange Defense Index , hit an all-time high on Thursday. The sequester will hit the military particularly hard, with defense programs set to be cut about 13 percent. Yet the index is up 7 percent this year.

Investors said continued support from the Federal Reserve, after Chairman Ben Bernanke mounted a strong defense of its economic stimulus this week, would blunt the effect of spending cuts.

"The stock market isn't worried. It's at five-year highs, and the sequester gives the Fed all the more reason to keep its foot on the gas," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.

What's more, markets have also been down this road before. In late 2012, investors and CEOs fretted over fears that the sequester, initially set to take effect in January along with $500 billion of tax increases, would cause a new recession.

A deal struck by Republicans and Democrats on New Year's Day averted most of the tax hikes but postponed the spending cuts until March 1. Major U.S. stock indexes rallied anyway, with the S&P 500 up 6 percent and the Dow up 7 percent since 2013 began.


Economists are not as relaxed. Many say that government belt tightening will put a brake on economic growth this year, whether or not the sequester happens.

The Congressional Budget Office, whose calculations are the building blocks of many Wall Street forecasts, has estimated fiscal tightening will knock about 1.5 percentage points from economic growth this year.

The spending cuts from the sequester make up a third of that, or 0.6 percentage points. A tax hike enacted in January will also drag on the economy, as will other spending cuts.

The cuts would also hurt the labor market, which would end the year with 750,000 fewer jobs than it would have if the sequester were avoided, according to CBO estimates.

To be sure, these worries have pushed some investors into the relative safety of U.S. government bonds, with the benchmark 10-year yield slipping to 1.84 percent this week after hitting 2.06 percent, its high for the year, on Feb. 14.

"There are concerns about the sequestration causing a dramatic slowdown in the economy," said Dan Heckman, senior fixed income strategist at Minneapolis-based U.S. Bank Wealth Management. "The budget negotiation related to the sequestration adds a great deal of uncertainty."

Bernanke, speaking to lawmakers on Wednesday, urged Congress to try to push spending cuts further out to the future to shield a fragile economy.

"If you slow the economy that hurts your revenues. And that means your deficit reduction is not as big as you think it is," he said.

Many investors, though, say the cuts, while annoying and painful, are too small a percentage of federal spending to do serious damage to the economy or have much impact on the deficit, which has exceeded $1 trillion for four years.


The question now appears to be how long the budget cuts will be allowed to happen. If budget cuts last only a few weeks, it is plausible they could have a marginal impact on growth and on employment. This is because some budget cuts won't translate into immediate spending cuts.

The Defense Department, for example, will probably not begin furloughing some 800,000 civilian workers until late April, after which these workers will work one day less per week. Budget cuts for capital spending could also be delayed.

The CBO estimates that only about half of the $85 billion in budget cuts planned from March through September would translate into lower spending during that period.

Once the furloughs and other spending cuts take hold, though, workers will feel the pinch, especially the 2.8 million people employed by the federal government.

"Their income is going to shrink considerably," said Omair Sharif, an economist at RBS in Stamford, Connecticut.

Tim Ghriskey, chief investment officer at Solaris Asset Management, said he thinks markets are betting all this will force Republicans and Democrats to the bargaining table.

President Barack Obama will meet congressional leaders in the White House on Friday for last-minute budget talks but hopes were low for a deal.

Whiteley said investors also realize that it will take months for furloughs and other cuts to be rolled out.

"If nothing happens today, that doesn't mean the economy crashes tomorrow. They have time to work on this," he said.

But perhaps not an infinite amount of time.

"The grace period is probably a month or two," Ghriskey said. "But if it becomes clear that these arbitrary cuts are starting to do damage and there's no sign of compromise, that's when the market could start to react."