As the fiscal cliff approaches, is the “Sell-off in America” about to make a comeback?

Source: Jinshi Data

The deteriorating fiscal situation in the United States is threatening the good mood on Wall Street.

Investors sold U.S. government bonds and the dollar on Monday after Moody's Ratings stripped the country of its last AAA credit rating last Friday, citing huge budget deficits and rising interest costs. More worryingly, the House Budget Committee passed a tax and spending bill on Sunday that is expected to add trillions of dollars to the deficit.

The sell-off pushed up yields on long-term U.S. Treasuries (yields rise when bond prices fall) even as stocks closed higher. The 30-year Treasury yield once broke through 5% and eventually fell slightly below that threshold, but remained close to its highest level of the year.

U.S. Treasury yields continued their weeks of climbing, driven by waning concerns about a recession, persistent concerns about inflation, and growing worries that larger deficits will lead to larger bond issuances. The increase in U.S. Treasury supply could outstrip demand, forcing the government to pay higher interest rates to attract investors.

The size of recent budget deficits has been particularly alarming to investors. That’s because they came during a period of economic strength, not a recession, when tax revenues plummet and governments increase spending to stimulate growth and help the unemployed.

“If we can run deficits of this size now, what’s going to happen when the economy is really in trouble?” asked Christopher Sullivan, chief investment officer at United Nations Federal Credit Union.

The 30-year Treasury yield closed at 4.937%, up from 4.786% at the end of last year, according to Tradeweb. The 10-year Treasury yield closed at 4.473%, up from 4.437% on Friday and up from less than 4.2% in late April.

The rise in Treasury yields has done little to slow a rally in stocks, which have rallied in recent weeks after the Trump administration rolled back some of its aggressive tariffs and as investors eased fears of a recession.

Nevertheless, investors are keeping a close eye on Treasury yields because of their role in determining borrowing costs across the economy. The S&P 500 rose 0.1% on Monday, the Dow Jones Industrial Average rose 0.3%, while the tech-heavy Nasdaq Composite was flat.

Coming into the year, many analysts viewed one of the biggest risks to stocks as a potential spike in Treasury yields if Republicans pass tax cuts without offsetting their costs.

Those concerns took a backseat after Trump announced a sharp increase in tariffs on April 2, as markets immediately worried that the economy could fall into a recession. But they have resurfaced recently, even before the Moody's downgrade, as long-awaited tax cut legislation takes shape in Congress.

After passing its latest hurdle on Sunday, the U.S. House of Representatives is expected to vote as early as this week on a proposal that would extend expiring tax cuts, add some new ones and reduce spending on Medicaid and nutrition assistance.

The proposal is expected to increase the budget deficit by about $3 trillion over the next decade, compared with what would have happened if the tax cuts were scheduled to expire on Dec. 31.

The United States has a long-standing imbalance between spending and tax revenue. Publicly held federal debt is about $29 trillion, nearly double what it was when Trump signed the original tax cuts in 2017. Nearly $1 of every $7 the United States spends goes on interest payments, more than it spends on defense.

The fiscal concerns could revive the "sell America" ​​trade that emerged last month, when foreign investors dumped U.S. assets, including Treasuries, on fears that isolationist trade policies could lead to a global war of capital.

"This has further fueled the 'sell America' trade, and you're already seeing that reflected," said Michael Arone, chief investment strategist at State Street Global Advisors.

"Investors are watching for changes in policy; they're also watching for changes in interest rates," Arone said. "That uncertainty is unsettling, and I think that's what the market is ultimately pricing in."

Several investors noted that concerns about the U.S. fiscal situation have dogged investors for years without causing sustained disruptions to the stock market. They said factors including changes in trade policy are more likely to affect the market in the short term.

"The market doesn't know what to focus on, it has to keep shifting," said Kevin Gordon, senior investment strategist at Charles Schwab.