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100% Dysfunctional, But Only .5% Disastrous

100% Dysfunctional, But Only .5% Disastrous

Kathy Lien, Technical Strategist

The impasse in Washington is dysfunctional, yes, but the dollar impact has been quite minimal so far, and with two full weeks left to avert a catastrophe, the impact of the shutdown isn’t likely to last long.

For the first time since 1996, parts of the US government have been shut down, and while this represents a historically significant level of dysfunction in Washington, the markets and foreign exchange traders specifically are taking the news in stride.

The US dollar (USD) is trading lower against most major currencies, but losses have been limited to less than 0.5% against the euro (EUR), British pound (GBP), Japanese yen (JPY), Canadian dollar (CAD), New Zealand dollar (NZD), and Swiss franc (CHF). The Australian dollar (AUD) is up by more against the dollar, but that is because of last night's less-dovish Reserve Bank of Australia (RBA) comments.

There hasn't been a dramatic reaction in currencies, and equities actually rallied because the shutdown is expected to be brief and not especially damaging to the US economy. It is estimated that a two-day shutdown will shave 0.1% off of Q4 GDP, and a week-long shutdown would reduce growth by 0.3%.

Of course, the longer the shutdown, the greater the pain, and in late 1995 and early 1996, when the US government was last shut down, the 21-day closure cut US growth by as much as 1.4%. So while consumer and business sentiment could take a hit from the shutdown, the economic impact will depend on how long it lasts.

See also: 4 Big Headlines the Market Just Shrugged off

Considering that the approval rating for Congress dropped to a record low, the political stalemate should end soon. According to the latest poll from CNN, only 10% of Americans approve of the job Congress is doing, and 87% disapprove of the recent actions.

By early yesterday, global investors came to realize that a shutdown was inevitable, and that left plenty of time to adjust their positions. The greatest underlying risk of the government shutdown and failure to raise the debt ceiling would be the first ever US debt default, which would be potentially catastrophic, and we believe traders are taking the shutdown in stride because most believe that both Republicans and Democrats will not play their political games to the point of a catastrophic default.

At this stage, shutdown-related negotiations will have to be rolled into the debt-ceiling debate. We believe the chance of default is less than 5% and that the government shutdown won't last for more than two weeks.

US Treasury Secretary Jack Lew has already indicated that the hard deadline is October 17, when the US Treasury would run out of money to pay its debts. The US dollar could remain under pressure until a compromise between the Senate and the House is reached, but the selloff should be moderate, and when a deal is reached, we expect losses to be recovered quickly.

See related: Despite Shutdown, Disaster Is Still 16 Days Away

In the meantime, dollar losses were also eased by better-than-expected US manufacturing activity, which accelerated in the month of September. The ISM manufacturing index rose to a near two-and-a-half-year high of 56.2, up from 55. The details of the report show an uptick in employment, production, and order backlog, although new orders grew at a slower pace.

By Kathy Lien of BK Asset Management

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