Lawmakers in Washington are back from their holidays and ready to resume talks on a budget deal. They have 5 days left to come up with a plan and based on the price action in the foreign exchange markets, investors are cautiously optimistic. Gains in the EUR/USD, GBP/USD and USD/JPY tell us that some traders expect Congress to announce a minimal deal to preserve jobless benefits and tax cuts for lower and middle income households by the end of the year but weakness in commodity currencies means the optimism is limited. At this point, the chance of a deal is 50-50. On Wednesday, the House promised to vote on anything the Senate approves, which is a small sign of progress but the “Senate has to act first.” However, the pressure on lawmakers also increased after Treasury Secretary Geithner notified Congress that the U.S. government would hit its statutory borrowing limit (debt ceiling) on Monday (December 31st). He will reshuffle some accounts to give the government $200 billion in breathing room which should buy Congress 2 more months to increase the debt ceiling but with no clarity on the tax code and government spending, it may not last that long.

For the next 5 days, investors will care about one thing and that is how the U.S. Fiscal Cliff talks are going. Currencies and equities will hold steady unless there is reason to believe that a deal will not be done by the end of the year OR early next year. If no deal is made by December 31st but Congress pledges to make an announcement in the first two weeks of January, investors may be willing to grant a grace period but if the talks break down, then selling could ensue.

The U.S. dollar is trading lower against all of the major currencies with the exception of the Australian and New Zealand dollars on the heels of mixed U.S. data. Labor market conditions continued to improve with jobless claims falling to 350K from 362K. The four-week moving average also dropped to its lowest level since March 2008 which points to the potential for a nice improvement in payrolls next week. New home sales rose 4.4% in November, which was stronger than expected. Low interest rates continue to provide support to the housing market but fiscal cliff concerns drove consumer confidence to its lowest level in 4 months.

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