David Morris

THERE has been a mixed reaction to the news that Congressional Republicans and President Obama have reached a deal to extend the Bush tax cuts. While a number of Democrats have expressed outrage that the cuts will continue for everyone, the package should be accepted. This helped lift US equities and by extension most other global stock indices.

Bond investors were less enthusiastic and yields rose sharply last week. While many analysts saw this as a reaction to improved growth expectations, others were less sanguine. After all, with the unemployment rate heading back towards 10 per cent and the housing market close to a double-dip, it could be argued that the American economy is a long way from making a meaningful recovery.

Some argue that higher Treasury yields are a response to the inevitable fiscal deterioration. The deal struck last week is seen as a cowardly political fudge. Without any reduction in government spending, the tax cut extension will only add to debt. And if the economic outlook has improved so much, the Fed should be considering winding down quantitative easing, not starting a debate about renewing it.

There is a very real danger that US state and municipal debt issues will be the next problem to require a bailout. California, Illinois and New York are among the most indebted and vulnerable states. There is evidence that investors are not only balking at the idea of buying fresh municipal bonds; they are actively selling.

Despite these concerns, the S&P 500 has broken back above significant resistance at 1,230. This marks the 61.8 per cent Fibonacci retracement of the move from the October 2007 high to the March 2009 low. It now seems to be consolidating above this level, which means there is a good chance that the index can build on this move and push higher into the year-end. So although last week’s surge in US bond yields has unnerved some, the bulls are confident that it won’t undo another positive year for equities.