The currency market kicked off the New Year with a bang after U.S. lawmakers finally reached a deal to extend unemployment benefits and tax cuts for 99% of Americans. In light of the fact that the U.S. economy fell off the Fiscal Cliff on Monday, this was the best scenario that we could have hoped for. With a crisis being averted for the time being, there’s a huge amount of relief in the markets. The U.S. dollar and Japanese Yen are trading lower across the board, fueling a solid rally in risk currencies. The British pound climbed to a fresh 1 year high intraday while the Yen crosses rose to multi-year highs. The rally in the EUR/USD has been limited but commodity currencies are up approximately 1%. The S&P 500 opened strongly on its first trading day of the year as European equities reached new highs. It is always good to see the enthusiasm shared by equity, currency and bond traders.

Unfinished Business in Washington

Yet we can’t help but mention that the rally in some pairs such as the EUR/USD and GBP/USD are fading. While investors have responded positively to the Fiscal Cliff deal, there’s a lot of unfinished business in Washington. Spending cuts still need to be negotiated along with additional tax reform and an increase to the debt ceiling. As quickly as they have penned the Fiscal Cliff deal, Congress will need to start negotiating a higher debt ceiling. The drama hasn’t ended because Republicans won’t readily agree to a higher debt limit without offsetting spending cuts, which the Democrats oppose. Some investors are also worried about the impact of the payroll tax hike on Americans. For someone making $50,000 a year, payroll taxes are expected to increase by $1,000. We don’t think the impact on spending will be too significant because the Fiscal Cliff deal should encourage U.S. corporations to start spending again and provide underlying support to the economy.

Risk of Downgrade

What we are more worried about is the psychological impact of a possible U.S. credit rating downgrade. Back in September, rating agency Moody’s threatened to downgrade the U.S. if it goes over the cliff. While a deal has been reached, it is not as ambitious as many had hoped for which means Moody’s could still move forward with the downgrade. Considering that S&P has already stripped the U.S. of its AAA rating, it isn’t a stretch for Moody’s to follow suit but if they were to do so, it could be psychologically damaging enough to drive investors back into safe have currencies.

US Data

In the meantime however, U.S. economic data surprised to the upside with manufacturing activity rising from a 3 year low in the month of December. The ISM index rose to 50.7 last month compared a prior reading of 49.5. The sector is expanding once again thanks to higher prices paid, order backlog, supplier deliveries, customer inventories, new export orders, imports and employment. While construction spending dropped 0.3% in November, the overall improvement in manufacturing activity paints a brighter outlook for the U.S. economy.

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