Uncertainty reigns in the fixed income market, and, surprisingly, it has little to do with the direction of interest rates.

The Fed, with its third round of quantitative easing, has telegraphed its intention to keep short-term interest rates near zero through mid-2015. At the same time, the QE programs that have been put in place are keeping longer term rates down as well. The current challenge for markets is less about Fed policy and more about politics: The looming fiscal cliff.

Russ has warned that there’s a better than a 50/50 chance that the nation goes over the fiscal cliff, meaning a combination of tax hikes and spending cuts would go into effect come January 1 that could crimp US GDP by 4% or more next year.

So, what’s a bond investor to do? I’ve already talked about flows we’re seeing into municipal bond ETFs as investors prepare ahead of the cliff.  But a recent paper from the BlackRock Investment Institute looks at three possible fiscal cliff outcomes – the sky dive, the bungee jump and the hard stop. I’d like to address those scenarios and their potential impact on fixed income markets.

1.)  A hard stop. This scenario means the United States sees a last-minute deal, with lawmakers extending most programs in return for some spending cuts. Lawmakers would then work toward a comprehensive budget deal in mid-2013. In this scenario, if there are signs that a real budget deal is in the works, we would likely see little impact on the fixed income market, as this appears to be what many investors in the market currently expect. But if the deal is seen as another Band-Aid, risk assets could sell off as investors become concerned about future disruptions arising from political gridlock. Of the three, this scenario would likely be the least disruptive for markets in the short term, and high quality segments of the fixed income market — like investment grade corporates and municipals — would likely continue to fare well.

Showing Page 1 of 2