With the debt ceiling extended, the risk of an catastrophic automatic pro cyclical Treasury response, as previously discussed, has been removed.

What’s left is the muddling through with modest topline growth scenario we’ve had all year.

With a 9% budget deficit humming along, much like a year ago when markets began to discount a double dip recession, I see little chance of a serious collapse in aggregate demand from current levels.

It still looks to me like a Japan like lingering soft spot and L shaped ‘recovery’ with the Fed struggling to meet either of its mandates will keep this Fed ‘low for long’, and that the term structure of rates is moving towards that scenario.

With the end of QE, relative supply shifts back to the curve inside of 10 years, which should work to flatten the long end vs the 7-10 year maturities. And the reversal of positions related to hedging debt ceiling risks that drove accounts to sell or get short the long end work to that same end as well.

The first half of this year demonstrated that corporate sales and earnings can grow at reasonable rates with modest GDP growth. That is, equities can do reasonably well in a slow growth, high unemployment environment.

However, a new realization has finally dawned on investors and the mainstream media. They now seem to realize that government spending cuts reduce growth, with no clarity on how that might translate into higher future private sector growth. That puts the macroeconomic picture in a bind. The believe we need deficit reduction to ward off a looming financial crisis where we somehow turn into Greece, but at the same time now realize that austerity means a weaker economy, at least for as far into the future as markets can discount. This has cast a general malaise that’s been most recently causing stocks and interest rates to fall.

With crude oil and product prices leveling off, presumably because of not so strong world demand, the outlook for inflation (as generally defined) has moderated, as confirmed by recent indicators. As Chairman Bernanke has stated, commodity prices don’t need to actually fall for inflation to come down, they only need to level off, providing they aren’t entirely passed through to the other components of inflation. And with wages and unit labor costs, the largest component of costs, flat to falling, it looks like the the higher commodity costs have been limited to a relative value shift. Yes, standards of living and real terms of trade have been reduced, but it doesn’t look like there’s been any actual inflation, as defined by a continuous increase in the price level.

However, the market seem to have forgotten that the US has been supplying crude oil from its strategic petroleum reserves, which will soon run its course, and I’ve yet to see indications that Lybia will be back on line anytime soon to replace that lost supply. So it is possible crude prices could run back up in September and inflation resume. For the other commodities, however, the longer term supply cycle could be turning, where supply catches up to demand, and prices fall towards marginal costs of production. But that’s a hard call to make, until after it happens.

With the debt ceiling risks now behind us, the systemic risk in the euro zone is now back in the headlines. Unlike the US, where the Treasury is back to being counter cyclical (unemployment payments can rise should jobs be lost and tax revenues fall), the euro zone governments remain largely pro cyclical, as market forces demand deficits be cut in exchange for funding, even as economies weaken. This means a slowdown to that results in negative growth and rising unemployment can accelerate downward, at least until the ECB writes the check to fund counter cyclical deficit spending.

China had a relatively slow first half, and the early indicators for the second half are mixed. Manufacturing indicators looked weak, while the service sector seemed ok. But it’s both too early to tell and the numbers can’t be trusted, so the possibility of a hard landing remains.

Japan is recovering some from the earthquake, but not as quickly as expected, and there has yet to be a fiscal response large enough to move that needle. And with global excess capacity taking up some of the fall off in production, Japan will be hard pressed to get it back.

Falling crude prices and weak global demand softening other commodity prices, looks dollar friendly to me. And, technically, my guess is that first QE and then the debt ceiling threats drove portfolios out of the dollar and left the world short dollars, which is also now a positive for the dollar.

The lingering question is how US aggregate demand can be this weak with the Federal deficit running at about 9% of GDP. That is, what are the demand leakages that the deficit has only partially offset. We have the usual pension fund contributions, and corporate reserves are up with retained earnings/cash reserves up. Additionally, we aren’t getting the usual private sector borrowing to spend on housing/cars as might be expected this far into a recovery, even though the federal deficit spending has restored savings of dollar financial assets and debt to income ratio to levels that have supported vigorous private sector credit expansions in past cycles.

Or have they? Looking back at past cycles it seems the support from private sector credit expansions that ‘shouldn’t have happened’ has been overlooked, raising the question of whether what we have now is the norm in the absence of an ‘unsustainable bubble.’ For example, would output and employment have recovered in the last cycle without the expansion phase of sub prime fiasco? What would the late 1990’s have looked like without the funding of the impossible business plans of the .com and y2k credit expansion? And I credit much of the magic of the Reagan years to the expansion phase of what became the S and L debacle, and it was the emerging market lending boom that drove the prior decade. And note that Japan has not repeated the mistake of allowing the type of credit boom they had in the 1980’s, accounting for the last two decades of no growth, and, conversely, China’s boom has been almost entirely driven by loans from state owned banks with no concern about repayment.

So my point is, maybe, at least over the last few decades, we’ve always needed larger budget deficits than imagined to sustain full employment via something other than an unsustainable private sector credit boom? And with today’s politics, the odds of pursuing a higher deficit are about as remote as a meaningful private sector credit boom.

So muddling through seems here to stay for a while.