The remarkable rebound in U.S. equities from the depths of the Covid-19 crisis in March faces a fresh test in coming weeks, with the American economy set for a withdrawal of a key stimulus support.

The average unemployment benefit for Americans put out of work will tumble by more than 60% at the end of July, hobbling the incomes of millions of laid off workers -- many of whom may not be able to return to their jobs given the renewed shutdowns now affecting swaths of the economy from California to Florida.

Stocks have proven resilient to plenty of bumps lately, from the surge in numbers of Americans infected with the coronavirus to a sharp escalation in U.S.-China tensions. The more risk-sensitive bond market has seen bouts of anxiety that have repeatedly pushed Treasury yields to record lows.

Now both contend with an impending fiscal cliff, with the political wrangling between Republicans and Democrats on a package expected to exceed $1 trillion just beginning.

“We’re getting into a second phase of people being laid off now that are going to be permanent or long term at the same time that benefits are set to go away,” said Thomas Graff, a portfolio manager in Baltimore at Brown Advisory, which oversees $80 billion. “That’s a major risk to the markets and nascent economic recovery.”

The legislative package is arguably nowhere near so critical to markets as the $700 billion financial bailout that was initially rejected by Congress in the depths of the Great Recession in September 2008 -- an error that saw the S&P 500 Index crash almost 9% in a day. But the assumption of the eventual passage of another stimulus bill has helped investors bear through another rough earnings season, and the rally could prove vulnerable if the bet proves wrong.

Second Half
With the S&P 500 up almost 43% from its March 23 low, there’s plenty hanging on a second-half economic rebound in the U.S. that could be endangered by a political impasse over the stimulus.

Uncertainty can already be seen in the bond market, where the yield curve has flattened, with the spread of longer-dated notes over shorter-term ones shrinking in the past month.

Complete failure to renew the added unemployment benefits would pose a 3 to 5 percentage-point hit to growth in the third quarter, according to Deutsche Bank AG. Also critical for renewed growth will be aid for state and local governments, whose spending accounted for more than a tenth of the economy last year and whose revenues have been decimated by the current recession.

On both counts, Republicans are pushing back against House Democrats who passed a $3.5 trillion bill back in May that was ignored by the Senate. The White House and some congressional Republicans argue the extra payments for people getting unemployment benefits serves as a disincentive to returning to work. Republicans have also raised objections about state aid, which some argue could be used for spending unrelated to the Covid-19 crisis.

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