U.S. assets are back in demand this morning on reports that Republicans and Democrats are moving closer to passing a temporary spending bill that would fund the government and extend its borrowing limit until late November, early December. For the past month, the financial markets have been held hostage by the U.S. debt crisis and investors are cheering the first signs of progress. However the gains are not expected to last because the government will be kicking the can down the road, leaving U.S. debt troubles to cripple the markets a month forward. The government is also expected to remain closed during the extension so despite less dovish FOMC minutes, the Fed will not be able to taper asset purchases this year.

Each week the government remains shutdown, U.S. GDP growth shaved by a minimum of 0.1%. Even if furloughed government workers receive back pay, the shutdown will still have a negative impact on consumer and business sentiment / spending. Between the drag on the economy and the nomination of Janet Yellen as Federal Reserve Chairwoman, the chance that the central bank will taper asset purchases this year has dropped to almost zero. The lack of reliable U.S. data also makes the Fed’s decision more difficult, which is another reason why we feel the gains in the dollar will be limited. U.S. jobless claims surged to 374k from 308k to its highest level since March but according to the Bureau of Labor Statistics the data was distorted by the recent computer upgrade and dismissal of U.S. government employees because of the shutdown. The delay in other economic reports and the distortion in jobless claims means no action from the Fed in October and if the government shutdown extends into December, the central bank won’t have enough reliable information to taper asset purchases at the end of the year.

Nonetheless equities are still trading sharply higher this morning and the U.S. dollar is up against all major currencies because investors are focusing on today’s progress. Ten year Treasury yields also broke 2.7%, hitting its highest level in nearly 3 weeks. With only 7 days left before the government is expected to run out of cash according to Treasury Secretary Lew, the best and only option for Congress at this stage is to kick the can down the road. However once the euphoria fades, the market should realize that delaying a resolution for 6 weeks means that fiscal troubles will remain a risk for the U.S. economy and the financial markets until Thanksgiving. So while we may see a further relief rally in the dollar and U.S. stocks this month, we expect the gains to be limited as parts of the government will remain shutdown as the battle in Washington extends into November. In other words, the problem has not been resolved, only pushed forward, extending the period of uncertainty for the U.S. and global economy. At best we expect no more than a 2% rally in the U.S. dollar with gains in USD/JPY capped below 100.

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