EUR Hangs Tight Ahead Of ECB Meeting

EUR Hangs Tight Ahead Of ECB Meeting

After rising to its strongest level in more than seven months, the euro backed off its highs to end the day unchanged against the U.S. dollar. The U.S. government shutdown for the first time in 17 years but investors did not abandon U.S. assets. Instead the dollar held steady against most pairs and the S&P 500 rallied. This unexpected performance in U.S. assets stripped away the euro’s earlier gains, leaving the currency stuck in the 125-point range that it has fluctuated in for the past nine trading days against the dollar. Even though the price action in the financial markets today suggests that investors expect a compromise before the U.S. government runs out of cash on October 17, other countries expressed concerns about the impact on the global economy. The RBA explicitly mentioned the U.S.’ fiscal problems in their monetary policy statement and there’s a reasonable chance that the European Central Bank will do so as well on Wednesday. The ECB is not expected to change monetary policy but given the surprise increase in German unemployment and the downward revision to German manufacturing PMI, the central bank is expected to remain dovish. The last time we heard from ECB President Draghi, he brought up the idea of another LTRO. While we don’t think the central bank is seriously considering another round of stimulus, LTRO talk, U.S. fiscal troubles and weaker data will keep the extended period guidance intact. We expect ECB President Draghi to remain dovish and this bias to add pressure on the euro.

The biggest disappointment in this morning’s German economic reports was the sharp rise in unemployment. Economists had been looking for unemployment to fall by 5k and given the sharp rise in the employment component of manufacturing PMI, we also believed the data would be strong but unfortunately unemployment rose by a whopping 25k. The German manufacturing PMI index on the other hand was revised down only slightly from 51.3 to 51.1.

US Markets Unfazed By Government Shutdown

The first U.S. government shutdown since 1996 means there is a historically significant level of dysfunction in Washington. Yet, investors have taken the news in stride. The U.S. dollar traded only slightly lower against most of the major currencies and U.S. stocks ended the day in positive territory with the Nasdaq climbing to its strongest level in more than a decade. Few investors are panicking because they expect the government shutdown to be brief and hence do little damage to the U.S. economy. It is estimated that a two-day shutdown will shave 0.1% off Q4 GDP and a week-long shutdown would reduce growth by 0.3%. Of course the longer the shutdown, the greater the pain. In late 1995, early 1996, the 21-day closure cut U.S. growth by as much as 1.4%. So while consumer and business sentiment could take a blow from the shutdown, the economic impact will depend on how long it lasts. 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 their recent actions.

By early yesterday, global investors also came to realize that a shutdown was inevitable and had plenty of time to adjust their positions. The greatest risk of a government shutdown and the failure to raise the debt ceiling is a default. While the U.S. government has been shutdown 17 times in the past, it has never defaulted on its debt or missed an interest payment. Part of the reason why FX traders are taking the government shutdown in stride is because most investors believe that both Republicans and Democrats will not play these political games to the point of a catastrophic default. At this stage, negotiations around a government shutdown will have to be rolled into debt-limit talks. We believe the chance of default is less than 5% and a government shutdown won’t last for more than two weeks. U.S. Treasury Jack Lew has already indicated that the hard deadline is October 17, when the U.S. Treasury runs out of money to pay its debts. The U.S. dollar could remain under pressure until a compromise between the Senate and the House is reached but the sell-off should be moderate and when a deal is reached, we expect losses to be recovered quickly. In the meantime, the losses were also eased by better than expected U.S. data. Manufacturing activity accelerated in the month of September as the ISM index rose to a nearly 2.5-year high of 56.2 from 55. The details of the report show an uptick in employment, production and order backlog but new orders grew at a slower pace. The ADP employment change report is scheduled for release on Wednesday. If the U.S. government is still shutdown on Friday, the Labor Department could postpone the release of non-farm payrolls.

GBP Hit By Weaker PMI Manufacturing

The British pound traded slightly higher against the U.S. dollar and euro following weaker than expected manufacturing data. Despite a sharp rise in the Confederation of British Industry’s manufacturing index, the more closely followed PMI report from Markit Economics dropped from 56.7 from 57.1 in the month of September. While the index remains significantly above its long-term average, the decline still saps the consistent trend of improving U.K. data. Since the beginning of August, sterling appreciated over 7% against the U.S. dollar. According to technical indicators, the GBP/USD is overbought and a correction off relatively decent data is not unusual. The details of the report show declines in every component except for employment, which is important because stronger job growth could help boost future demand. Halifax house prices and the U.K.’s construction sector PMI report are scheduled for release tomorrow. Since the housing market has been the shining star of the U.K. recovery, we expect these releases to confirm continued strength in the sector.

AUD: Lifted By Good Data And RBA

The best performing currency today was the Australian dollar, which traded sharply higher against all of the major currencies. Despite the decline in gold prices, solid economic data and less dovishness from the RBA helped to lift the currency. Australia’s manufacturing sector expanded for the first time since June 2011, retail sales rose 0.4% and new home sales rose 3.4%. In response to these improvements, the Reserve Bank left interest rates unchanged and noted the improvement in business and consumer confidence. They also feel better about household savings behavior, a view they was dropped the previous month. The RBA did not mention the level of the currency, which investors interpreted to mean they are comfortable with the current AUD/USD rate. The combination of stronger data and less dovishness from the RBA pushed the prospect of another rate cut to February of next year. The New Zealand and Canadian dollars on the other hand traded lower against the greenback due in part of softer Chinese manufacturing PMI numbers. According to the government’s official report, manufacturing activity expanded only slightly in the month of September. This slowdown in growth is consistent with the PMI report released by HSBC and together they raise concerns about a short-lived recovery for China. It is too early to say but a global recovery hinges on the sustainability of China’s recovery. Australian trade balance and building approvals are scheduled for release this evening and given the rise in the manufacturing PMI index, we see scope for a further upside surprise that could extend gains in the AUD.

JPY: Abe Hikes Consumption Tax But Forgoes Corporate Tax Cut

The Japanese Yen strengthened against all of the major currencies today except for the Australian dollar. As everyone had anticipated, Prime Minister Abe announced that the consumption tax would be increased from 5% to 8% in April. This levy is expected to raise 8 trillion yen of which 5 trillion will be recycled back into the economy in the form a new stimulus package. The details of the program will be provided in December but according to the Cabinet Office, it will include public works spending and tax breaks. Unfortunately Abe stopped short of announcing the one thing the market was really hoping for – a reduction in corporate taxes. However based on the rally in thee Nikkei and the price action of USD/JPY, all hope is not lost. Very few details were provided on the stimulus package because there is a divergence in views among the ruling party about how corporate taxes should be changed. Abe said the decisions will be made in December and his vow to eliminate a tax surcharge and reduce corporate taxes means there could still be a chance that corporations will receive relief as well. Japanese assets also benefitted from stronger data. The Tankan survey rose to its highest level since the collapse of Lehman Brothers, a sign that Japan’s recovery will gain momentum. Unfortunately this uptick was offset by a drop in household spending and labor cash earnings along with a rise in the jobless rate.

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