Dollar Won’t Collapse if No Fiscal Deal by Oct 17

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Daily FX Market Roundup 10-15-13

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management

**Traveling for the rest of the week. Next piece will be on Monday October 21

Dollar Won’t Collapse if there is No Fiscal Deal in by Oct 17
EUR: Shrugs Off Sharp Rise in ZEW
GBP: Potential Upside in Labor Market Data
AUD: Up RBA Minutes but Struggles to Sustain Gains
CAD: Hit by Weaker Housing Market Data
NZD: Q3 CPI on Tap
JPY: Abe Kicks Off 53 Day Special Diet Session

Dollar Won’t Collapse if there is No Fiscal Deal in by Oct 17

For the past 2 weeks, investors have been hopeful that Congress will pass a bill that will avoid the first ever default but fifteen days into the U.S. government shutdown and with just under 36 hours to go before the Treasury reaches its borrowing limit, their optimism is fading quickly. Stocks resumed their slide today, carry traders were liquidated and the U.S. dollar extended its losses against most of the major currencies after the White House rejected the House proposal and talks in the Senate broke down. To date, currencies and equities are seeing a controlled sell-off even after rating agency Fitch put the U.S. rating on negative watch, but many investors fear that if the U.S. default on its debt, the dollar will collapse.

Thankfully October 17th is a soft and not hard deadline. While we would like to see a deal reached before Thursday, at this stage, it is growing increasingly unlikely. Last month, U.S. Treasury Secretary Jack Lew said “We estimate that on October 17th, Treasury would have only approximately $30 billion to meet our country’s commitments. This amount is far short of net expenditures on certain days, which can be as high as $60 billion. The key words are “certain days.” The U.S. government won’t miss its first bond payment exactly on October 17th, but it can happen shortly thereafter. To buy themselves time, they can prioritize certain payments but this strategy is not sustainable especially since there is a major benefits payment due on November 1st, which many view as the real doomsday.

So while we expect the dollar to extend lower if the October 17th deadline, we don’t expect the greenback to drop another 5 or 10%. If Congress manages to pass a bill to raise the debt ceiling and reopen the government by Monday, it would still be enough time to avoid a default. The biggest holders of U.S. Treasuries are central banks and they will most likely wait a few days to see how much longer Congress will let their dysfunction continue. If the U.S. were to default on its debt, it would only be a technical default but the historical significance won’t be lost amongst investors who would sell U.S. assets as soon as the headline hits the wire and then again when rating agencies put the country’s sovereign debt rating on selective or restricted default. However we do not expect a 5 to 10% sell-off in the U.S. dollar and breakdown in Treasuries because the main buyers of Treasuries are central banks who are less sensitive short term changes in the U.S. fiscal outlook. Also we don’t expect an immediate liquidation out of money market funds. The Treasury market is still the largest market in the world and these central banks realize that a massive exodus out of Treasuries would cause U.S. bond yields to spike, leading to spillover affects into their own markets. Once the debt ceiling is raised, the U.S. rating should be restored. Back in 2011 when S&P stripped the U.S. of its AAA rating for the first time ever, investors sold dollars immediately but the Dollar Index dropped only 1.5%. It then consolidated near its lows for a few weeks before recovering strongly over the next 2 months. So we do expect the dollar to weaken but we don’t anticipate an all out collapse if a deal is not reached by October 17th.

EUR: Shrugs Off Sharp Rise in ZEW

The euro traded lower against all of the major currencies today despite a sharp rise in investor confidence. Apparently the problems the U.S. are not enough to rattle investors who have clearly turned positive on the outlook for the German and by extension, Eurozone economy. German investor confidence rose for the third month in a row to its strongest level in 3 years as low unemployment leads investors to expect a stronger recovery in the region’s economy. While the Eurozone still faces a significant amount of risks, the outlook is shifting. Investors aren’t completely blind to the current market environment, as they grew less optimistic about current conditions but the expectations component of the ZEW surged to 52.8 from 49.6. The Eurozone on the other hand saw a far more modest increase in confidence with the index rising to only 59.1 from 58.6. Unfortunately the European Central Bank is in no position to alter its dovish monetary policy bias because the improvements in Eurozone economy are still at its infancy. However if we see consistent upside surprises in data and the U.S. fiscal crisis comes to an end, we could see the EUR/USD climb to a new 1 year high above 1.3710.

GBP: Potential Upside in Labor Market Data

The British pound extended its gains against the euro and U.S. dollar on the back of hotter consumer prices. CPI grew 0.4% in the month of September and this increased kept annualized CPI growth at 2.7%. This stronger reading should fuel expectations for earlier tightening by the Bank of England. The central bank has signaled that the first rate hike will not be until 2016 but the market is pricing in a move in mid 2015. While hotter inflation is a key component in the BoE’s decision, this week’s employment and retail sales report should be even more important. The number of people filing for unemployment claims is expected to drop by a smaller amount in September versus August with average weekly earnings growth easing slightly. We believe there’s scope for an upside surprise because the PMI reports show improvements in labor market conditions. Retail sales on the other hand may not fare as well with the British Retail Consortium reporting a significant slowdown in spending. As such, we expect mixed reports to keep rate hike expectations intact for the being as 2015 let alone 2016 is a long time from now and market expectations could change significantly between now and then.

AUD: Up RBA Minutes but Struggles to Sustain Gains

The Australian and New Zealand dollars ended the day slightly higher against the greenback but both currencies gave up a large part of their earlier gains after budget talks broke down in Washington. Investors may be wary about owning U.S. dollars but the risk that a U.S. default poses to the global economy also encouraged liquidation out of high beta currencies. At one point today, the Australian dollar was trading at its strongest level since June but by the end of the North American session, AUD was only slightly higher against the greenback. The earlier enthusiasm for the currency was driven by neutral RBA minutes. As reported by our colleague Boris Schlossberg, the Reserve Bank “noted that there is a substantial degree of policy stimulus and that it will continue to gauge its effects. For now the RBA noted that the rate cut is not imminent, but it left open the possibility for further rate cuts if needed.” Despite the risks posed by U.S. fiscal uncertainty, the central bank remains cautiously optimistic as the pressure from low confidence and the strong currency eases. They are also optimistic about the outlook for China and the improvements in Japan’s economy, which suggests that they will be comfortable with keeping interest rates at its current level for the rest of the year. Central Bank Governor Glenn Stevens will be speaking on Friday and investors will be watching closely for guidance on monetary policy. If Stevens is also optimistic and Chinese GDP numbers which are due that same day meets or beats expectations, we could see further gains in AUD. The Canadian dollar on the other hand ended the day lower against the greenback after weaker than expected housing market reports. Sales slowed in the month of September while house prices stagnated. Given the vulnerability of Canada’s economy to the U.S. economy, it is not a surprise to see the currency underperform the AUD and NZD in current times. No major economic reports were released from New Zealand but the country’s quarterly CPI figures are due this evening and price pressures are expected to rise, which will help build the case for tightening in 2014.

JPY: Abe Kicks Off 53 Day Special Diet Session

The breakdown in U.S. budget talks drove the Japanese Yen sharply higher against all of the major currencies and if there is no deal by tomorrow we could see another 1% slide in the Yen crosses. USD/JPY in particular could erase all of its recent gains and drop below 97. Over the next 24 hours, the market’s risk appetite will continue to be the primary driver of currency flows. The Yen will fall if Congress magically produces an eleventh hour deal but if they fail, we expect the Yen to move lower as more investors liquidate out of Yen crosses. However, the U.S. is not only country whose politics are worth watching. Last night, Prime Minister Abe kicked off the government’s 53-day extraordinary Diet session. At this meeting, policymakers will finalize the details of the 5 trillion yen stimulus package, the third arrow of Abenomics. This includes important discussions surrounding a reduction in the corporate tax rate and various tariffs. Flushing out Abenomics won’t be easy but the mandate of encouraging investment is clear. The government hopes to establish special economic zones with less regulation in the hopes of boosting business investment. The session runs to December 6th, after which lawmakers are expected to announce the details of their plans. Yet 53 days is a long time especially compared to the imminent risk of the U.S. breaching its debt limit and for this reason, Japanese fundamentals have taken a backseat to the U.S.

Kathy Lien
Managing Director

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