With the turmoil in Washington far from clear, the threat of US default seems an actual possibility, symbolically at least even if not in practice. I have previously described this situation as a pathetic and risky publicity stunt.
My view hasn’t changed, but my frustration at the ridiculousness of the US political system has increased parabolically. The US has money. They can afford to pay all of their debts, so this is a case of won’t pay rather than can’t pay, which has drawn criticism from emerging market leaders, the world bank, and now even China are taking pot-shots at Tea Party Republicans.
The solution, if we get one this week, is very European in nature, it’s simply shifting the problem slightly down the road. However the obvious expectation that this will not be sorted any time soon has meant that a previous solution, which meant the problem would re-emerge during peak Christmas shopping period, has been squashed with early New Year now favourable for another showdown. This doesn’t exactly fill me with confidence that a solution will be found because it intrinsically implies that the issue will be unresolved at the end of the extension and cause disruption to a critical retail period.
This week’s treasury bond auctions didn’t go too badly considering the situation, which unfortunately gives US politicians more elbow room to chase their tails and shifts the theoretical point at which the US government ‘runs out of money’ slightly further away, however this is ignoring the issue.
What the US needs is some good old fashioned bond market vigilantes, but who is big enough to take on the Fed and their asset purchase facility? China are the biggest stake holder, but they have painted themselves into a corner since any selling of US denominated assets will weaken their dollar exchange rate and hurt their export sector. Japan also hold considerable amounts of US debt but are equally into a corner for the same reason.
Regardless of what happens, deal or no deal, any hopes for a taper any time soon have been vaporised. If anything, the government may need to increase asset purchases to undo the damage caused by this whole debacle. As such, any US dollar rallies should be faded once any initial solution euphoria has tarnished and the market suddenly remembers that the Dollar is now less likely to rally in the medium to long term as a result of this.
Bernanke made it perfectly clear that the US would only taper after a continued period of positive Labor market data improvement, but since we’re not even getting Non-Farms data currently, it seems safe to say that this key indicator for taper will need numerous positive releases once they start again to understand whether to taper or not, or whether the economy is going to falter due to the shutdown.
There is another point to consider though and that is the safe-haven status of the Dollar, although this would be only due to the global reserve nature of the Dollar rather than the safety of its credit. My feeling is that the Yen will take the brunt of any negative news and flight to safety, no mater how fundamentally ridiculous that is. No doubt Kuroda is currently having kittens about that prospect and the stability of the world’s number three economy is currently at risk if there becomes a sustained rally in the Yen to undo the massive stimulus program from the BoJ. The dollar could eventually see a bid though off the back of the safe-haven status and the markets could return to risk-on / risk-off behaviour.
Here are the possible outcomes this week:
A deal ahead of the deadline
A deal this week will likely see the Dollar rally initially against risk currencies however this will likely be faded and a longer period of Dollar weakness may emerge due to worries of an extension to the asset purchase facility. Yellen will really not want to drop the ball on her first attempt so the safest solution is to continue with the asset purchases.
No deal in time, but short term bills get paid
No deal this week, but everything gets paid while the government remains shut down will likely cause a knee-jerk reaction for Dollar downside due to the sentiment of the situation and most other currencies should rally considerably against the Dollar. The market will likely wait for the situation listed below before really getting going though. We are approaching the point at which longer term short position in EURUSD and GBPUSD may become unwound if we rally much higher, which could see those pairs accelerate higher. The Pound has the furthest to rally so expect EURGBP weakness to accompany this.
No deal in time and default on debt
No deal and a default on debt will have the above effect but also cause chaos in the bond markets. Rating agencies will downgrade the US (why has this not happened already? are they mad?!). If this turns into something major rather than the possibility of something major then we had better batten down the hatches and hark back to the good old days, when small fry like Greece couldn’t pay their debts. The markets would be a mess in a very unpredictable way. Japan’s export sector would suffer considerably and place a question mark over their enormous debt. Europe would suffer from a less competitive Euro and the green shoots of recovery throughout Europe would be trampled on, placing the global recovery at risk.
By Mark Lewis