Debt ceiling risk looms as cliff averted Sorry to interrupt the celebrations, but the relief rally on a deal to avert the US fiscal cliff has a few sceptics. The new year showdown was resolved with an agreement that prevents the US economy dipping back into recession, according to the emerging consensus. But it has also poisoned the chances of a more comprehensive solution to the country's long-term budget problems, set up a terrifying fight over the federal debt ceiling, and may also have doomed the country to another credit rating downgrade. Markets had approached the cliff - in which the world's largest economy was about to impose tax rises and spending cuts of a scale large enough to tip it back into recession - remarkably calmly, says Ajay Rajadhyaksha, head of rates and securitised products research at Barclays. The Vix volatility index, a gauge of market fear, remained subdued, equity markets had not retreated far from their summer highs and US Treasury yields remained above their lows. A powerful relief rally propelled stocks and other risky assets sharply higher on Wednesday. But all that could change and the rally go into reverse if the Republicans follow through on their threat to use the debt ceiling as a bargaining chip in the next round of budget negotiations, which are likely to reach their culmination towards the end of February. That is when a $1.2tn plan to cut federal spending over 10 years is expected to begin, and when Congressional authorisation for current federal spending needs to be extended. It is also roughtly when the government will hit its $16.4tn debt limit and be unable to pay all its bills. If Congress misses that deadline for a deal, the federal government could be shut down, savage spending cuts could go into effect or - a worst case scenario - the country may default on its bonds. "No one worried that the US government will fail to make good on its credit if it goes over the fiscal cliff," Mr Rajadhyaksha says. Ironically, in that scenario, its balance sheet improves as taxes rise. If taxes go up for one payroll cycle, that is not the end of the world. If the US hits the debt ceiling and misses one single debt payment, however, then it has crossed the Rubicon. The difference in stakes between a cliff and a ceiling can be seen in the Vix index. It did creep higher to 22.72 as Congressional infighting opened the possibility of a full cliff dive last week, but it never approached the high of 48 in August 2011, when the politicians last fought to the wire over raising the debt ceiling. For a few moments in the summer of 2011, the unthinkable was thought: namely, that US T-bills, used as collateral in trillions of dollars of financial transactions and as the bedrock of global money markets, might go into default. Even without the debt ceiling wild card, the prospect of a long budget fight could still have negative consequences for the market, because it could still have consequences for the US economy. Paul Ashworth, chief US economist at Capital Economics, says Congress's failure to make a "grand bargain" that would resolve its long-term budget issues, opting instead only for a smaller tax deal, has prolonged the uncertainty holding back consumer and business spending. "We had hoped that a comprehensive agreement would prompt a wave of spending by households and businesses who are currently sitting on the sidelines due to uncertainty about fiscal policy," he told clients. Any upside risk to our forecast from pent-up demand may now have gone, for a few more quarters at least. There could be particular volatility in defence sector stocks, since the fiscal cliff deal delayed rather than renegotiated the additional $55bn in annual cuts to the Pentagon budget that are part of the so-called "sequester." The aerospace and defence sector was underperforming the wider S&P 500 at Wednesday lunchtime. Jim Paulsen, chief investment strategist at Wells Capital Management, was among the optimists, saying even a brief respite from political drama will be positive for markets. It ends, for now, the cliff and allows focus among investors to return to fundamentals, which are not too bad. The US is growing faster than most thought, China is re-emerging and eurozone calamity fears have calmed," he says. The grand bargain that the White House and Republican Speaker John Boehner have twice now failed to reach is aimed at cutting the US budget deficit by $4tn over 10 years, and to bring the deficit to GDP ratio closer to a sustainable 3 per cent. An open question today is how much longer the rating agencies will give them to come to an accord. Barclays, Capital Economics, National Alliance Securities and others are forecasting more downgrades this year, on top of Standard & Poor's move to strip the US of its AAA rating in August 2011. "The Congress only seems to be able to agree the lowest common denominator," says Mr Rajadhyaksha. That sends a very poor signal to the rating agencies. Additional reporting by Mary Watkins in London