For the first time since 1996 parts of the U.S. government has been shut down and while this is represents a historically significant level of dysfunction in Washington, the markets and foreign exchange traders specifically are taking the news in stride. The U.S. dollar is trading lower against most of the major currencies but its losses have been limited to less than 0.5% against the EUR, GBP, JPY, CAD, NZD and CHF. The only reason why the AUD is up more against the USD is because of last night’s less dovish RBA comments.
There hasn’t been a dramatic reaction in currencies and equities even rallied because the shutdown is expected to be brief and do little damage to the U.S. economy. It is estimated that a 2-day shutdown will shave 0.1% off Q4 GDP and a week-long shutdown would reduce growth by 0.3%. Of course the longer the shutdown, the more pain. In late 1995, early 1996, the 21-day closure cut U.S. growth by as much as 1.4%. So while consumer and business sentiment could take a blow from the shutdown, the economic impact will depend on how long it lasts. Considering that the approval rating for Congress dropped to a record low, the political stalemate should end soon. According to the latest poll from CNN only 10% of Americans approve of the job Congress is doing and 87% disapprove of their recent actions.
By early yesterday, global investors also came to realize that a shutdown was inevitable and had plenty of time to adjust their positions. The greatest risk of a government shutdown and the failure to raise the debt ceiling is a default. While the U.S. government has been shutdown 17 times in the past, it has never defaulted on its debt or missed an interest payment. Part of the reason why FX traders are taking the government shutdown in stride is because most investors believe that both Republicans and Democrats will not play these political games to the point of a catastrophic default. At this stage, negotiations around a government shutdown will have to be rolled into debt-limit talks. We believe the chance of default is less than 5% and a government shutdown won’t last for more than 2 weeks. U.S. Treasury Jack Lew has already indicated that the hard deadline is October 17th, when the U.S. Treasury runs out of money to pay its debts. The U.S. dollar could remain under pressure until a compromise between the Senate and the House is reached but the sell-off should be moderate and when a deal is reached, we expect losses to be recovered quickly.
In the meantime, the losses were also eased by better than expected U.S. data. Manufacturing activity accelerated in the month of September as the ISM index rose to a nearly 2.5 year high of 56.2 from 55. The details of the report show an uptick in employment, production and order backlog but new orders grew at a slower pace.