Talking Points:

Dollar Drops after Debt Talks Stall, Fitch Warns on US Rating
British Pound Rallies Against Dollar, Euro on Mixed Inflation Data
Euro Lower Across the Board Despite USD-Alternative Appeal

Dollar Drops after Debt Talks Stall, Fitch Warns on US Rating
The saga continues. Despite optimistic prognoses from politicians in both parties and arms of the Legislative branch at the start of the week, the US is still without a solution to its rapidly approach debt ceiling deadline. Yet, the fear that this ‘worst case scenario’ could inflict hasn’t spread through the market evenly. In fact, there is remarkable optimism in the form of ‘long risk’ speculation in equities, complacency with the directly afflicted US dollar and serious concern seen in the short-end of the Treasury curve. This inconsistency is partly confusion as to what exactly the implications of this impending event are; but there is also an element of gratuitous optimism that a happy resolution is around the corner.

Should there be a last minute save to push back the debt ceiling to 2014 and end the government standoff before the Treasury’s October 17 deadline, there is still substantial uncertainty that will be alleviated leading to a relief rally for both the S&P 500 as a standard for risk trends as well as the US dollar (playing the role of the US market benchmark rather than traditional safe haven). Yet, after the House of Representatives called an end to the discussion Tuesday night with clear discord between the intended bills between it and the Senate; the risk of an unfavorable outcome increased materially.

In this situation, an outcome that falls into the ‘grey’ area is likely. As it has been pointed out, October 17 is a flexible date for the debt ceiling. According to Treasury Secretary Lew, the US will still have an estimated $30 billion to cover needs; but a swell in expenditures could quickly push the country into arrears. Such an occasion is called a ‘Drop Dead’ date, but it is unclear exactly when that would occur. If an agreement was hashed out during this period of limbo, there would likely be a greater relief rally – which would first insinuate that dollar and equities retreat before the respite was realized.

In the short-term, investors may realize that crossing the line in the sand didn’t lead to an instant catastrophe and be emboldened short of an actual breakdown in the funding markets. However, the long-term implications stand to be severe for dollar and the US in general. Over the past five years, there has been an international campaign amongst major economies to diversify away from the US as sole reserve due to the trouble realized following the subprime housing contagion (though that was merely a spark for much derivative fuel). In this brinkmanship situation, that effort will be hastened. With Fitch – credit rating agency – warning that the US is at risk of losing its AAA-status and short-term Treasuries (often considered cash equivalents) yields soaring, there is a strong argument for diversification.

British Pound Rallies Against Dollar, Euro on Mixed Inflation Data
The sterling boasted a notable performance against its benchmark US and Euro-area counterparts this past session, but that doesn’t necessarily speak to the currency’s innate strength. When we look at its performance across the board, the day was notably split. Looking at the event risk the market was absorbing; the dense round of inflation news had a noticeably mixed feel. The headline read was the Consumer Price Index (CPI) figure for September which produced a headline read of 2.7 percent which escaped the expected downtick. In general, that does offer rate hawks fodder for their expectations; but not much. It should be noted that we are below the 3.0 percent threshold the BoE needs to write a letter above; and when the CPI figure was above that level between December 2009 and April 2012, the BoE maintained the benchmark at 0.50 percent. Meanwhile, upstream inflation (Core PPI) cooled to a June 2005 low. That said, 10-year gilt yields did hit 3-week highs.

Euro Lower Across the Board Despite USD-Alternative Appeal
What is the most viable reserve alternative to the US dollar? If we go by reserve and transaction volume figures from the Bank of International Settlements (BIS), that would be the euro. And yet, this past session’s US government standoff didn’t encourage much appetite for the shared currency. In fact, the currency dropped against most of its counterparts. On the local docket, the Eurozone ZEW investor sentiment survey hit a four-year high (59.1). Meanwhile, Italy announced a budget that aimed for 2.5 percent debt to GDP in 2014, while Portugal kept its 4.0 target.

New Zealand Dollar Rate Outlook Improves after 3Q CPI
New Zealand’s 3Q CPI figures beat expectations. A 0.9 percent increase in price pressures over the period outpaced the consensus, but it was the 1.4 percent year-over-year pace that stands out. While this is still well below the target – much less excessive – level, it is a significant pickup from the near 13-year low set in 2Q. While it is not an overwhelming confirmation of an impending RBNZ rate hike, it does support hawkish positioning. A 26-month high in 10-year New Zealand bond yields and 81 bps of hikes priced in swaps over 12 months is carry friendly.

Australian Dollar Firms in Wake of RBA Minutes, Risk Still Key
The RBA’s minutes Tuesday morning may have been more neutral than hawkish, but that is enough of a shift from the steady rate cut regime of the past two years to support the carry currency to recovery. The Aussie dollar gained against all but the Japanese yen – which traded direction for volatility. The 12-month rate forecast is at a 28-month high (18 bps of hikes) and 10-year yield a 19-month high (4.268 percent).

Japanese Yen Crosses See Volatility and Tight Congestion
With numerous shifts in risk trends through the US session with each update on the US debt standoff this past session, the yen crosses were driven on multiple volatile swings. This has lifted short-term (one-week) implied volatility for USDJPY and other yen-based pairs off 2013 lows, but it does given proper weight to the risk of breakout on these key pairs. Until there is a clear outcome for the US, volatility may dominate.

A Day Closer to US Default Helps Lift Gold Out of its Volatility Fears
There is a lot for gold to overcome. Its bouts of volatility this year have severely undermined its alternative store of value appeal and a distinct lack of yield had diminished its appeal during a period where investors have bent over backwards for return. It takes a lot to offset this concern. Of course, fear that the world’s reserve currency is facing acute risk certainly exploits that situation. Gold rose 0.8 percent this past session – though it is still a 1.5 percent rally from $1,300. A side-by-side breakdown from the dollar and S&P 500 could cover that ground.

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