The risk of holding U.S. dollars skyrocketed after this morning’s weaker than expected non-manufacturing ISM report. Service sector activity slowed significantly in the month of September with the ISM index dropping to 54.4 from 58.6. While the manufacturing sector expanded at a faster pace last month, the U.S. is a services based economy and this slowdown combined with the drag of the government shutdown, has driven the chance of Fed tapering this year significantly lower. The details of the ISM report also show a significant slowdown in labor market conditions, a signal that non-farm payrolls could surprise to the downside. Investors will have to wait for government offices to reopen to see how payrolls fared in the month of September but in the meantime they may lower their expectations for payrolls and their demand for dollars after this week’s reports. At 308k, jobless claims were relatively healthy but we all know that fewer layoffs do not automatically mean more hiring.

The move in U.S. Treasury Bills is also getting a lot of attention this morning. The one-month T-bill rate rose to its highest level since November and this is the first tangible sign that investors are worried about a default. Credit default swaps also surged by the largest amount since 2009. The U.S. government has never defaulted on its debt and we don’t think they will now but some investors are beginning to hedge against this possibility. If the U.S. debt ceiling is not raised by October 17th, the government would start missing interest payments, putting the country at risk of default and until Congress reaches a compromise, it will be difficult for the dollar to rally. Knowing that a default would trigger a chaotic reaction in the global financial markets, we firmly believe that the Obama Administration will do everything in their power to avoid it. One option would be for the President to invoke authority under the 14th Amendment and order the federal government to keep borrowing. This was a strategy suggested by President Clinton during the budget showdown in 2011. Republicans would scream for an impeachment and the Supreme Court may have to vote on its legitimacy but this is a route that many Democratic leaders are urging the President to seriously consider. The U.S. government could also sell other assets such as gold but none of these options are as palatable as an increase to the debt limit.

The longer the political showdown in Washington continues, the greater the chance that the Fed will defer tapering until 2014. We are in day 3 of the shutdown and if public offices are not reopened by the end of the week, it could subtract as much as 0.25% off U.S. GDP. The drag on the U.S. economy is not the only reason why the government closure could delay a reduction in asset purchases. According to Fed President Rosengren, who is a voting member of the FOMC this year, the shutdown also affects data gathering and could “put out further into the future the time when we can get a real assessment.” He said “it would make me less willing to remove accommodation until we had good data.” Given the significance of the decision to taper, there’s a good chance Rosengren’s views will be shared by many of his colleagues at the Federal Reserve, some of whom are speaking today. If the shutdown extends beyond next week, it may be very difficult for the Fed to justify reducing asset purchases in December and at this stage, we should forget about a move in October.

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