The US debt-ceiling debate has weighed on the dollar and stocks, but it seems unthinkable and unlikely that political posturing will cause the US to default on its debt, which is the only truly deadly outcome.
The US dollar (USD) extended lower while stocks dropped more than 1% Thursday on the back of growing concerns that the US government will default on its debt. Another day has now passed with no meaningful progress in Washington, and as a result, the risk of default has increased. The Senate refuses to accept anything outside of a clean spending bill, while the House refuses to disconnect the Affordable Care Act—commonly known as Obamacare—from its spending bill.
Despite the growing risks, we firmly believe that Congress and/or the Obama Administration will not let the government miss any interest payments because the consequences are just too catastrophic. Furthermore, since we haven't seen an all-out collapse of the dollar and stocks, most investors probably feel that the chance of default is very slim as well.
Nonetheless, the market is eyeing the move in US Treasury bills with both caution and fear. The one-month T-bill rate rose to its highest level since November today, while credit default swaps surged by the largest amount since 2009. The US government has never defaulted on its debt, but some investors are now hedging against this possibility.
See related: 2 US Budget Resolutions to Consider…and Fast
In addition, the longer the political showdown in Washington continues, the greater the chances that the Federal Reserve will defer tapering of asset purchases until 2014. In fact, Atlanta Fed President Dennis Lockhart said point blank that the government shutdown vindicates the Fed's decision to delay tapering, which virtually eliminates the chances for a move this month.
2 Catalysts Catapulting the Euro (EUR)
The euro (EUR) extended higher on the back of better-than-expected economic data. Eurozone retail sales surged in the month of August despite slower consumer spending in Germany and France. PMI services were also revised higher thanks to stronger activity in France and Italy. Unfortunately, Germany seems to be the weakest link these days, as the country’s PMI manufacturing and services were both revised lower this week.
EURUSD has been a big beneficiary of the recent improvements in the Eurozone data and concerns about the US debt ceiling, and the pair has been helped further along by the ongoing resolution of Italy's political crisis.
The last step remaining is the expulsion of former leader Silvio Berlusconi, and the Senate will begin that process tomorrow. They will have to decide whether his conviction on charges of tax fraud is a violation of an anti-corruption law. If the sub-committee recommends that he be expelled, the full Senate would vote on the matter in the coming weeks.
Italy's political crisis is not completely behind us, but Premier Enrico Letta's victory significantly weakens Berlusconi's influence, and if and when he is finally expelled, we could see another relief rally in the euro. In the meantime, EURUSD has climbed to its highest level in seven months, and from here, there's no major resistance for the pair until its one-and-a-half-year high of 1.3710.
GBPUSD Hit by Sudden Profit Taking
While the UK economy has been performing very well, the latest PMI reports suggest that the recovery may be losing momentum. Today, we learned that service sector activity slowed slightly, with the PMI services index falling from 60.5 to 60.3. The index remains near record highs, but combined with the slight declines in the PMI construction and manufacturing reports, it has been enough for some sterling traders to cut their long positions.
House prices also failed to grow at a faster pace last month, according to Halifax. We still believe that the UK economy will outperform and that the Bank of England (BoE) is done easing, but for the time being, we would not rule out additional profit taking in sterling. No UK economic reports are scheduled for release on Friday.
By Kathy Lien of BK Asset Management