CB Meetings, Payrolls And Dysfunction In Washington

Many traders may be frustrated by the decline in volatility in the foreign exchange market. 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 limited the move in currencies. Investors have very little confidence in the U.S. government's next steps and have refrained from any major changes to their positions. With a very busy data calendar and the fiscal showdown in Washington coming to a head today everyone's hope is that volatility will finally increase this week. Unfortunately that may not be the case because in order for volatility to explode, leading to breakout moves in currencies, the outcome of this week's event risks need to be surprising enough that it changes the near to medium term outlook for the U.S. economy or causes investors to gives up hope that a compromise will be reached quickly.

Clock's Ticking
In less than 16 hours at 12:01am ET on Tuesday, large parts of the U.S. government could be shut down if Congress fails to agree on temporary way to fund the government. Over the weekend, the House voted in favor of a spending bill on the condition that Obama's healthcare law is delayed by 1 year and a medical devices tax, which was used to pay for the program is repealed.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 it is approved by the Senate. With only hours to go before the key October 1st deadline, the risk that the U.S. government will shutdown for the first time in 17 years is growing by the minute. The dollar extended its losses against the Japanese Yen but is trading steady against other major currencies. The U.S. government has been shut down 17 times before and the last was in late 1995, early 1996 when the dollar index fell less than 1% during the 1 month period because a resolution was reached quickly. While Republicans and Democrats continue to play their political games, both parties know that the consequences of default border on catastrophic and so even if the government is shutdown, we believe there will be temporary funding measure to avert a default that will limit the volatility in the dollar. If a shutdown could be avoided completely, the dollar could benefit from a relief rally that mean weakness for the EUR/USD and recovery for USD/JPY.

Data Watch
Meanwhile we don't believe this week's ISM and Nonfarm 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 nonfarm payrolls is expected to increase 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 policymakers confirm that tapering has been deferred and not canceled and therefore yields should resume their rise. The lack of clarity provided by U.S. data on monetary policy could keep volatility in the FX market limited. The central banks of Australia, the euro zone and Japan will be meeting this week and no changes are expected. The RBA and the ECB will most likely be dovish with the former leaving the door open to additional easing and the latter talking about another LTRO. In Japan on the other hand, the bigger focus will be on fiscal policy. Tonight, Prime Minister Abe is expected to officially announce that the consumption tax will be increased to 8% from 5% in April. In order to cushion the blow, the Japanese media have reported that the Abe will also announce a stimulus package worth more than Y5 trillion that 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. The focus will therefore be on their economic package and growth strategy and how much support to the economy will be provided. USD/JPY has been trading in a narrow range for the past 12 weeks and fiscal surprises from Washington or Japan could trigger a breakout.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.