Dollar Extends Losses but Don’t Expect a Default

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Daily FX Market Roundup 10-03-13

Dollar Extends Losses but Don’t Expect a Default
EUR Extends Gains on Stronger Data
GBP: Weaker Data Triggers Profit Taking
AUD: No Support from Stronger AU and Chinese PMI
NZD: Shrugs Off Hawkish RBNZ Comments
CAD: IVEY PMI Due Friday
JPY: What to Expect from the Bank of Japan

Dollar Extends Losses but Don’t Expect a Default

The U.S. dollar extended lower while stocks dropped more than 1% today on the back of growing concerns that the U.S. government will default on its debt. The Senate refuses to accept anything outside of a clean spending bill while the House refuses to disconnect the Affordable Care Act from their spending bill. Another day has passed with no meaningful progress in Washington and as a result the risk of default has increased. However we firmly believe that Congress and/or the Obama Administration will not let the U.S. government miss any interest payments because the consequences are just too catastrophic. Since we haven’t seen an all out collapse of the dollar and stocks, most investors probably also feel that the chance of default is very slim.

Nonetheless the market is eyeing the move in U.S. Treasury Bills with caution and fear. The one-month T-bill rate rose to its highest level since November while credit default swaps surged by the largest amount since 2009. The U.S. government has never defaulted on its debt but some investors are hedging 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. The U.S. government has options – one possibility 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.

With this in mind, the risk of holding U.S. dollars has still increased especially 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 longer the political showdown in Washington continues, the greater the chance that the Fed will defer tapering until 2014. In fact, Fed President Lockhart said point blank that the government shutdown vindicates the Fed’s decision to delay tapering. While he feels they would not rule out making the decision in October we think the chance the Fed will reduce asset purchases this month is zero.

EUR Extends Gains on Stronger Data

The euro extended higher on the back of better than expected economic data. Eurozone retail sales surged in the month of August despite slower consumer spending in Germany and France. PMI services were also revised higher for the region thanks to stronger activity in France and Italy. Unfortunately Germany seems to be the weakest link these days with PMI manufacturing and services revised lower this week. EUR/USD has been a big beneficiary of the recent improvements in the Eurozone data and concerns about the U.S. debt ceiling. Italy’s political crisis is also nearing an end. The last step is the expulsion of former Prime Minister Berlusconi. The Senate begins the process of expelling Berlusconi from government tomorrow. They will have to decide whether his conviction tax fraud is a violation of an anti-corruption law. If the subcommittee recommends that he be expelled, the full Senate would vote on the matter in the coming weeks. Italy’s political crisis is not completely behind us, but Letta’s victory significantly weakens Berlusconi’s influence and if and when he is finally expelled, we could see another relief rally in the euro. In the meantime, the single currency has climbed to its highest level in 7 months and there’s no major resistance for the pair until its 1.5 year high of 1.3710.

GBP: Weaker Data Triggers Profit Taking

For the first time in 5 trading days, the British pound weakened against the U.S. dollar. The sell-off in sterling was so strong that it also triggered a very sharp rally in EUR/GBP. While the U.K. economy has been performing very well, the latest PMI reports suggest that the recovery may be losing momentum. Today we learned that service sector activity slowed slightly with the PMI services index falling from 60.5 to 60.3. The index remains near its record highs but combined with the slight declines in the PMI Construction and Manufacturing reports, it has been enough for some sterling traders to cut their long positions. House prices also failed to grow at a faster pace last month according to Halifax. We still believe that the U.K. economy will outperform and that the BoE is done easing but for the time being we would not rule out additional profit taking in sterling. No U.K. economic reports are scheduled for release on Friday.

AUD: No Support from Stronger AU and Chinese PMI

Better than expected Australian and Chinese data failed to lend support to the AUD. Service sector activity accelerated in both countries with Australia’s PMI index rising to 47.1 from 39.0, a jump that took the index to its highest level in 6 months. Every one of the underlying components with the exception of wages increased and this along with the improvement in manufacturing activity suggests that Australia is still on the path to recovery. The increase in service sector activity in China also bodes well for Australia. While the improvement in both manufacturing and services was small, the world’s second largest economy is still rebounding and that is good news for the region. The lack of economic data from Canada kept the pair in consolidative mode but volatility in the pair could increase with tomorrow’s IVEY PMI report. The New Zealand dollar on the other hand gave back part of Wednesday’s gains despite optimistic comments from RBNZ Governor Graeme Wheeler. In an op-ed for the New Zealand Herald, Wheeler outlined the reasons behind their recent decision to restrict high LVR mortgages and explained that if this fails to “slow house price inflation, larger increases in the official cash rate could be required.” These hawkish comments should have driven the NZD higher but the currency sold off against the USD, EUR, and AUD.

JPY: What to Expect from the Bank of Japan

Weaker than expected U.S. data kept USD/JPY under pressure while the rest of the Yen crosses treaded water with the exception of NZD/JPY and GBP/JPY, which extended their recent losses. The Bank of Japan will end its monetary policy meeting tonight and we believe they will leave policy unchanged. The central bank is comfortable and confident about the strength of the recovery and their positive sentiment is validated by the recent Quarterly Tankan report which rose to its strongest level since 2008. Some economists fear that the BoJ is overly optimistic but data has been good. The latest services PMI business activity index rose to 53 in September from 51.2, a sign of continued recovery. Right now, the Japanese economy can do with its current level of stimulus but if Prime Minister Abe raises the consumption tax in April without cutting corporate taxes, the Bank of Japan may have to sweep in with another round of stimulus. However we have 6 months till April so more QE is not on the agenda right now for the BoJ and instead, we expect continued optimism. According to the Ministry of Finance’s weekly portfolio report, Japanese investors bought foreign bonds for the third straight week. Foreign demand for Japanese stocks have also been strong, suggesting that global investors are dipping toes into the Nikkei, creating offsetting demand for Yen.

Kathy Lien
Managing Director

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