Forex: Dollar – Is a Government Shutdown Bullish or Bearish?

Talking Points:

Dollar: Is a Government Shutdown Bullish or Bearish?
Euro Faces Heavy Event Risk in ECB Decision, Italy Reckoning
Japanese Yen: Does a Tax Hike Equate to Risk Aversion or More BoJ Stimulus?

Dollar: Is a Government Shutdown Bullish or Bearish?
There is a broad contrast in market interpretations of whether a US government shutdown hurts the dollar or general risk trends (USD bullish) more. Yet, the general lack of market volatility in response to this high profile event is surprising traders on both sides of the aisle. Is the fiscal and political impasse not a pertinent concern for the US and global capital markets? It does carry an important fundamental influence. Each day that the government remains shut, the US economy suffers an estimated $300 million loss. Extend this stalemate multiple weeks, and the total economic impact can carve off a significant percentage of the fourth quarter US GDP. Yet, as material as this daily tally is, it is not particularly shocking for a market that has maintained its speculative bearings through worse over the years.

However, the longer a budget agreement is not met; the weightier the speculative fear will become. By Treasury Secretary Jack Lew’s estimates, in just over two weeks (October 17 to be precise) the United States will reach its debt limit. If the country were to breach that barrier, the implications would be far more material. In contrast to the orderly funding cuts to specific federal programs during the shutdown, the curb of capital in the alternative scenario would be disorganized and costly. Perhaps most importantly of all, the US would face a technical default as it prioritizes payments to debtors. Fear of further downgrades for the world’s largest economy and the funding disruptions could materially unnerve global sentiment – the August 2011 downgrade is a good indication of that. With each day that passes in the government shutdown, the sense of internal strife as the more important decision approaches grows. Meanwhile, risk trends are not beholden to US politics alone. There are many other sparks that can set off a speculative run (bullish or bearish); so FX traders should remain vigilant.

Euro Faces Heavy Event Risk in ECB Decision, Italy Reckoning
The euro is the most at-risk major currency over the next 24 hour trading period. Over Wednesday’s trading session, we have two key events that can stir volatility for the euro and European markets. Up first, Italian Prime Minister Letta is scheduled to address Parliament about the chaos that has befallen the countries government at 7:30 GMT (9:30 local). After five members of the cabinet announced their resignation and Silvio Berlusconi’s People of Liberty Party (PdL) threatened to withdrawal support of the troubled coalition government, the EZ’s third largest economy – suffering an ongoing recession and holding Europe’s largest debt load – was labeled a reemerging risk to the region’s stability. That said, recent reports of up to 40 possible defectors from the PdL could tame this immediate risk. The other top tier event on deck is the ECB rate decision. Aside from a reminder of the OMT’s presence, little is expected. Yet, that consensus offers generous surprise opportunity.

Japanese Yen: Does a Tax Hike Equate to Risk Aversion or More BoJ Stimulus?
This past session, Japanese Prime Minister Shinzo Abe announced his intentions to move forward with an increase to the national sales tax from 5 to 8 percent. Given Japan’s over 200 percent public debt to GDP (unprecedented in the developed world), the move is considered essential to working off the balance and holding onto critical investor confidence. Alternatively, a tax hike can curb an uneasy economic recovery. To help offset the detrimental impact to growth, the premier had also confirmed a ¥5 Trillion stimulus program – though the details are still vague. In response, the yen crosses are modestly softer. So far, the market is not equating tax hike to more BoJ stimulus.

New Zealand Dollar Leads an Early Risk Aversion Drive
Through a mild risk aversion shift early Wednesday, the New Zealand dollar was notably leading the high yield / risk pack with the steepest drop and notable breaks versus the USD, JPY and AUD. Why does the major with the highest market rates (its 10-year Treasury yield is 4.58 percent versus the Aussie’s 3.97) and most impressive rate forecast (pricing in approximately 75 basis points of hikes over the coming 12 months) taking the biggest hit? There was headline fodder worth taking note of. RBNZ Assistant Governor John McDermott remarked that rates should remain stimulatory for some time, but those comments crossed the wires well after the initial move and are not particularly damning. A more fitting reason for the kiwi to suffer the most is that it had the most to lose. At one point, the kiwi’s rate forecast was nearly 100 basis points worth of hikes over the coming year. The bleed in premium alongside that tempered forecast acted as a risk accelerant.

British Pound Stalls Immediately after GBPUSD Breakout, Troubled
The sterling managed a modest advance against most of its major counterparts, but there was little conviction to the drive. Over the past five months, the currency has gained serious traction thanks to a swing in rate forecasts that can be seen in the over 85 percent surge in the 10-year Gilt’s yield. Yet, the forward shifted rate hike expectations that the market ran the projections on have contradicted the BoE’s repeated warnings, and the market is starting to take head after the premium swell. If risk aversion takes down global rate forecast, the cable will be hardhit.

Australian Dollar Outlook Still Leans Bullish Post RBA
The Reserve Bank of Australia (RBA) announced Tuesday morning that they had kept policy unchanged and that they did not expect to alter the benchmark lending rate through the foreseeable future. That would typically be considered a non-event; but for a carry currency that has been battered by a regime of rate cuts, no change is a bullish shift. The Aussie dollar is still sitting at a significant discount due to the speculative shorts riding a steady dovish regime. Yet, the full recovery effort will only be realized if the appetite for yield rises (aka risk appetite).

Gold Tumbles on a Swell in Demand for a Dollar Alternative?
One of gold’s historical fundamental roles is as an alternative store of wealth. This served the metal especially well from 2009 through 2011 when the dollar’s value was eroded by tremendous swell in stimulus by the Federal Reserve. Yet, where is that boost now? After the FOMC decision two weeks ago to defer the ‘Taper’, the precious metal popped higher as expected. With the overnight US government shutdown, though, that connection was broken. When the US markets came online, the precious metal tumbled as much as 3.4 percent from the headline – crashing through $1,300 in the process. Not only does this counter the expected reaction, but the intensity of the commodity’s run stood out against a backdrop of inaction. Meanwhile, the CBOE’s gold volatility index has risen above 25 percent while SPDR Gold ETF volume posted its fourth highest volume turnover (16.7 million shares) in three months. More important than this break is follow through.

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EUR

Italian Budget Balance (euros) (SEP)

-9.2B

With the political crisis driving yields higher, previous estimates of the budget might end up on the optimistic side.