With this week’s Fed decision still impacting the financial markets, attention is now shifting to the debt ceiling debate and the potential for currency wars, both of which are raising concerns once again.
Some investors may still be digesting the implications of the Federal Reserve decision to maintain its current pace of asset purchases, but the market is already moving on to the debt ceiling debates, the prospects for a government shutdown, and developing currency wars.
After selling off sharply following yesterday’s Federal Open Market Committee (FOMC) announcement, the US dollar (USD) has since stabilized and even recovered its losses against the Japanese yen (JPY). The rapid-fire gains in USDJPY caught many by surprise, but were brought on by new highs in the Nikkei, which helped to lift all yen pairs, and the prospects for more stimulus from the Bank of Japan (BoJ).
The Debt Ceiling Debate Is Back
The risk of a government shutdown is perhaps one of the main reasons why the central bank decided to keep policy steady. For the past four months, the US government has been using emergency measures to avoid breaching the $16.7 trillion debt ceiling, and based on the current level of spending, the government could run out of cash by October 1, which could force a government shutdown in late September.
The last time the US government was officially shut down was 1995 and into 1996 during the Clinton Administration. In both cases, the dollar index dropped more than 0.65% before quickly recovering once Federal offices were reopened.
As a result, FX traders shouldn't be overly concerned about a government shutdown because the dollar impact is expected to be short-lived, but nonetheless, Treasury Secretary Jack Lew has urged Congress not to wait until the eleventh hour to raise the debt ceiling.
Rumblings About a “Currency War” Emerge, Again
Meanwhile, the Fed’s decision has already begun to have global repercussions. When Fed Chairman Ben Bernanke talked tapering back in July, it drove global bond yields higher, creating a headache for other central banks. Now, the decision to delay a reduction in asset purchases may also pose a problem for the BoJ, Reserve Bank of Australia (RBA), and Reserve Bank of New Zealand (RBNZ), all of which have been banking on USD strength to ease pressure on their respective currencies.
If those nations’ currencies continue to strengthen versus the dollar, the central banks may have to offset the drag on the economy with easier monetary policies, a development which some feel could plunge the world back into a currency war.
We believe that the risk of a currency war heating up because the Fed decided not to taper is overblown because easy monetary policy should provide underlying support for the US recovery, which will help boost the export activities of other nations.
Furthermore, tapering is still inevitable and should occur within the next six months. Considering that today’s US economic data, which included Philly Fed manufacturing, as well as leading indicators and existing home sales, came in better than expected, the dialogue about Fed tapering this year remains alive, although at this stage, a move in 2014 is much more likely.
By Kathy Lien of BK Asset Management