US Dollar Set for Breakout, Risk and Budget Standoff Decide Magnitude
Fundamental Forecast for US Dollar: Neutral
- The last minute standoff in Congress to avert a government shutdown creates risk for markets and perhaps dollar benefit
- Budget issues and NFPS aside, the normalization of activity levels and risk trends create a favorable USD backdrop
- If the dollar begins to run on risk trends or default concerns, look to the Dollar Currency Basket for trading options
The USDollar carved out an incredibly restrained 50 point range this past week – directly after the Fed held course on stimulus. Yet, this suspicious period is likely to explode moving forward as we face critical event risk after critical event risk. A reversal in activity is almost certain considering what lies ahead for the benchmark currency and capital markets at large. However, direction, amplitude and consistency of this revived activity depend on how the fundamentals play out and how close to the bone the risk trends cut.
Before considering the many events and indicators that we should be monitoring this coming week, it is important to keep the state of underlying speculative conditions in mind. Investors are extraordinarily leveraged, inactive and exposed. Looking to the US equity market, borrowed funds at NYSE brokers is just below the record highs set this year. For activity measures, we can refer to the USDollar’s exceptionally small trading range, the lowest non-holiday trading volume on EURUSD futures since 2009 or the lowest realized (actual) volatility on the S&P 500 since June 2007. The signal is the same.
It would seem – as the saying goes – that the markets are ‘priced for perfection’. In reality, they are dependent on perfection to maintain the status quo. There is an inescapable bias behind these conditions. There are few and unlikely scenarios where activity returns and it prove immediately beneficial to risk appetite. More likely, a rise in participation is likely to accompany volatility – itself considered a measure of ‘risk’. That is a troubling relationship for the benchmark US equity indexes as they attempt to maintain record highs. However, for the safe haven greenback; that is a fundamental spark that can replace diminished taper premium.
With that speculative prejudice in mind, we are facing a mine field of event risk. Top priority for the billowing smoke and building heat coming out of Washington. There is an October 1 deadline for Congress and the President to sign off on an emergency spending bill to avert a government shutdown. This is not the critical event that immediately leads to the risk of impending default – that comes on October 17 according to Treasury Secretary Lew – but it is significant enough that it can undermine investor confidence and further stymie an economic recovery. The trouble lies in the Republican-controlled House of Representatives push for a bill that includes a delay or complete halt to the Affordable Care Act (nicknamed ‘Obamacare’) legislation passed in 2010 and set to start this year. The President and Democrat-controlled Senate have rejected negotiation over the add-in.
Congress is expected to continue debating the bill over the weekend, but time is running preciously low even for the routine of passing the legislation and sending it to the other house. The true risk in this event for the market is the fact that there seems little effort to price in possible fallout. While we have seen sovereign US credit default swaps swell, Treasuries, equities and certainly the FX market have made little adjustment to a negative outcome. This event does not need to singe-handedly alter the landscape for investors. Rather, this could prove enough of a ‘trigger’ to jump start momentum on a risk run.
Aside from the Government Deadline, there is deep well of event risk facing the dollar through the week. The IMF will release its updated 2013 economic outlook as well as its Global Financial Stability Report for investors to weigh. Closer to home, we have the ISM’s manufacturing and service sector surveys which act as a good proxies for broader economic activity.
Bookmarking the week, the top indicator on the calendar will be the September nonfarm payrolls (NFPS). This indicator’s importance is questionable given the FOMC’s decision on the 18th to hold off the ‘Taper’. Though, with the next policy meeting set for October 30, this piece of data will likely be key to determining whether the Fed merely delayed to avoid a ‘perfect storm’ with fiscal budget problems or if they were genuinely concerned about current conditions. If the market interprets a near-term Taper, it can revive a major concern for global capital markets and may trigger risk trends in the way that the previous policy meeting couldn’t. – JK