Political Paralysis To Leave Dollar Vulnerable

by: Dean Popplewell

Global investors are going about their own business with having to keep an eye on the U.S. budget impasse progress. The partial U.S. government shutdown has the capability of rocking global confidence levels if it continues to drag on for much longer. The longer the political standoff persists, the greater the risk there is to U.S. growth, and the greater the chance that it would derail any possibility that the Fed would begin to wind down its $85b a month bond buying program anytime soon.

A prolonged shutdown would fuel risk aversion, which would be negative. Various asset classes up to now had been trading under the guise that the U.S. government shutdown would be a short-lived affair. As the political gridlock continues, the market's perceptions about just how long the government shutdown could last will start to change. Investors are beginning to ask the question if this could be similar to the government shutdown of 17-years ago, which saw a -1.4% of GDP loss as federal agencies were closed for three-weeks. The ongoing political stone throwing between the Democrats and Republicans leaves the dollar vulnerable across the board. Waiting to see who blinks first could mean the dollar's underperformance is here to stay for some time.

U.S. Congress' actions are sowing the seeds of a debt-ceiling crisis. Yes, funding the government is an issue but a greater concern is the U.S.’s ability to pay its debts. If lawmakers don’t raise the limit on federal borrowing soon, they will put their own country at risk of defaulting on some of its legal obligations. Congress has until October 17 before the Treasury exceeds its borrowing capacity, which means the U.S. will no longer be able to pay all its bills in full. The longer the shutdown, then debt rating agencies become an issue - the U.S. debt ceiling is not itself a downgrade trigger, but a formal ratings review with potentially negative implications would be triggered if the government does not raise the debt ceiling in a timely manner.

The lack of reported progress and apparent absence of overlap in the two parties’ positions would suggest that the shutdown is about to be extended beyond this week. To date, the various asset classes appears to have largely discounted the U.S. government shutdown – any further uptick in politicking around the debt ceiling debate could undermine some of the recent risk rally the market has enjoyed. Playing fast and loose with the debt ceiling will put global markets on the back foot very quickly – currently they are finely poised.

The FX market was rather subdued during the euro session despite the "political paralysis" stateside. Even Germany has had the time to take the day “officially” off. Released activity reports among the eurozone's businesses picked up at the fastest rate in two-years last month as growth, previously confined to the backbone economy of Europe – Germany – is beginning to spread further afield and include economies like Italy and France. The composite Purchasing Managers Index rose to 52.2 in September, up from 51.1 the previous month. Yesterday Draghi described the risk to growth was to the downside. Data like this is proof that the euro recovery is now more widespread, but it remains questionable because of the “deep rooted problems yet to be addressed by euro policy makers.” Some southern economies remain constrained. Spanish business activity shrank – “sputtering after a long economic downturn.” Similar to other periphery economies the country suffers from high unemployment and a wounded banking system.

In three months GBP has risen 10% – rallying from its yearly lows to this year's high this week (1.6260). The market is somewhat confused by its strength. Everyone believing in a less dovish Fed and a stronger U.S. economy would be leaning towards a pro-dollar. However, strong data continues to support sterling. Activity in the U.K.’s dominant services sector remained strong this morning, helping to post the best quarter in 16-years for services PMI reports. Last month's print of 60.3 was little changed from August's 60.5 release and provides an encouraging sign that further advancements will persist in the coming months.

Believing that U.K. growth could hit 1% in Q3 or 4% annualized has led to rising gilt yields. There is skepticism in the market with the BoE “forward rate guidance.” With GBP’s current value, markets will find it difficult to be pricing in any rate hikes anytime soon. Governor Carney has pledged to keep rates low until unemployment hits +7%. This will be difficult with stronger economic reports suggesting that the BoE accommodative stance is providing more of an economic boost that previously thought. The “Old Lady” meets next week with the market about to take on Carney.

Despite an increasingly bullish picture, the 17-member single currency is finding it difficult to maintain its strong momentum well above the 1.3600 levels. If the currency pair is capable of penetrating the 1.3625 level with gusto, it certainly opens up the topside for the technical gurus towards 1.3700. The uncertainty over the U.S. shutdown will cramp any risk appetite, but so many investors believing a longer shutdown will lead to a weaker dollar does not change the overall market bullish sentiment for the EUR in the short-to-medium term.

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