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The Perfect Storm That Killed Volatility

The Perfect Storm That Killed Volatility

Kathy Lien, Technical Strategist

The ongoing US debt ceiling debate and looming government shutdown, inconclusive US data, and Italy’s own political crisis have combined to handcuff the markets and brought volatility to a screeching halt.

Many traders may be frustrated by the decline in volatility in the foreign exchange market, but between the dysfunction in Washington, Europe's own political problems, and mixed messages from Federal Reserve officials, the heightened level of uncertainty in the financial markets has limited moves in currencies. Investors have very little confidence in the US government’s ability to avoid a looming shutdown and have refrained from any major changes to their positions as a result.

See related: 2 Political Crises Gripping the Globe

With the economic calendar very busy and the fiscal showdown in Washington coming to a head today, everyone's hope is that volatility will finally increase this week, but unfortunately, that may not be the case. In order for volatility to return and breakout moves in currencies to result, the outcome of this week's event risks either needs to be 1) surprising enough that it changes the near- to medium-term outlook for the US economy, or 2) so bad that it causes investors to gives up hope that a compromise will be reached quickly.

In just a matter of hours, at 12:01 am ET Tuesday, large sections of the US government could be shut down if Congress fails to agree on a temporary way to fund operations. Over the weekend, the House voted in favor of a spending bill on the condition that Obama's healthcare law is delayed by one year, and that a medical devices tax, which was to be used to pay for the program, is repealed.

The controversial healthcare law has been the cornerstone of the debt ceiling debate, and even before the House voted, the Senate majority leader said they would oppose the Republican measures, and according to the White House, the President would veto the House bill if approved by the Senate.

Meanwhile, the US dollar (USD) extended its losses against the Japanese yen (JPY) but was still holding steady against other major currencies.

With only hours to go before the key October 1 deadline, the risk that the US government will shut down for the first time in 17 years is growing stronger by the minute. Last time a shutdown occurred was in late 1995 and early 1996, although the dollar index fell by less than 1% during the one-month period because a resolution was reached quickly.

This time, however, with Republicans and Democrats continuing to play their political games, both parties know that the consequences of a US debt default border on catastrophic, and as a result, even if the government is shut down, we believe there will be temporary funding measures to avert a default, which would limit volatility in the dollar.

If a shutdown could be avoided completely, though, the dollar could benefit from a relief rally that would drive weakness in EURUSD and a recovery for USDJPY.

US Data May Suppress Volatility, too

Aside from the political problems, we don't believe this week's ISM and non-farm payrolls reports will make the central bank's decision about tapering any easier. Manufacturing and service sector activity is expected to expand at a slightly slower pace, while non-farm payrolls are expected to have increased slightly in September.

As only mild changes are expected, it may not be enough for policymakers to change their bias. As long as the data isn't terrible, we expect the dollar to remain firm because recent comments from key Fed officials confirm that tapering has been deferred, not canceled, and therefore, yields should resume their rise. The lack of clarity provided by US data on monetary policy could keep volatility in the FX market limited.

A Key Policy Change Expected This Week

The central banks for Australia, the Eurozone, and Japan will all be meeting this week, and no policy changes are expected. The Reserve Bank of Australia (RBA) and European Central Bank (ECB) will most likely be dovish, with the RBA leaving the door open for additional easing and the ECB talking about another LTRO.

In Japan, on the other hand, the bigger focus will be on fiscal policy. Tonight, Japanese Prime Minister Shinzo Abe is expected to officially announce that the consumption tax will be increased starting in April to 8% from 5% currently. In order to cushion the blow, Japanese media have reported that Abe will also announce a stimulus package worth more than JPY 5 trillion, which could include a corporate tax cut.

Since the consumption tax has been widely discussed, the official announcement is not expected to have a major impact on the markets unless Abe decides not to raises taxes. Instead, the focus will be on the economic package and growth strategy, and how much support to the economy will be provided. USDJPY has been trading in a narrow range for the past 12 weeks, and fiscal surprises from either Washington or Japan could trigger a breakout in the pair.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.