Anxiety is on the rise in assuming that the fiscal cliff will bring trouble for the economy if the $500 billion in scheduled tax hikes and spending cuts is allowed to kick in come January. But guess what? The pain has already started, courtesy of the forward-looking focus of the capital markets.

The stock market in particular is adjusting accordingly amid the self-inflicted pain that Washington seems intent on dispatching to the country. The S&P 500 is down about 7% since mid-October and the slide will probably roll on without progress on defusing the fiscal-cliff threat.

“I see very little to be optimistic about right now until we get some more clarity on these pressing issues,” Randy Frederick, managing director of active trading and derivatives at Charles Schwab & Co., tells the LA Times.
The crowd is inclined to agree, a view that’s reverberating throughout the markets. The benchmark 10-year Treasury yield has been falling consistently for the past month, dipping to 1.58% yesterday—the lowest since the end of August. The market’s implied inflation forecast is fading too. The yield spread on the nominal 10-year Treasury less its inflation-indexed counterpart yesterday inched down to 2.38%, or the lowest since September. The preference for safety isn’t a good sign. The fact that investors are willing–still–to chase Treasuries at such painfully low rates says a lot about sentiment these days.
None of this is surprising. Risky assets taking it on the chin and a new round of disinflation/deflationary winds are blowing. There’s still time to short-circuit this train wreck, but time is running short. The truly sad part is that the economic data has been decent lately, and if the fiscal cliff was a non issue it wouldn’t be hard to imagine that the prospects for growth would be fairly encouraging right about now. But that’s all on hold because of you know what.
The economy for the moment is at the mercy of politics in Washington. Not surprisingly, the results are ugly. What skill set might get us out of this mess? A flair for herding cats comes to mind.