More Pain For Next Week's Dollar?

Based on the price action in the financial markets today, investors are not worried that the U.S. will default on its debt. Stocks rallied, bond yields moved higher and the dollar strengthened against the euro, British pound and Japanese Yen. According to Treasury Secretary Jack Lew, Wall Street should be more concerned because a failure to raise the debt limit would cause the stock market to tumble and President Obama warned that it could lead to recession. We have no doubt that the consequences of a default would be severe and that investment wealth in the U.S. and other parts of the world would suffer but there is little sense of panic in the financial markets. The risk of default is slim but even so, the dollar doesn't deserve to rally today because policymakers in Washington aren't any closer to a compromise. There's a very good chance the government will be closed for another week and when investors realize that on Monday, the dollar could give up its gains.While we don't anticipate an all out collapse in the greenback because we believe Congress has no choice but to resolve their differences, in the coming week, owning dollars can be risky. Aside from the fiscal troubles in Washington, the minutes from the most recent FOMC meeting will also be released. Despite the government shutdown, the Federal Reserve is open for business, which means the minutes will on schedule. To the market's surprise, the Federal Reserve decided to maintain its current level of asset purchases last month. However according to the many Federal Reserve Presidents who have spoken since that meeting, it was a very close call. If the minutes show a significant amount of support for tapering this year, the dollar could recover its losses but the gain could be limited by the latest fiscal troubles, delay in data and potential drag on growth. If there was a significant amount of caution even before the government shutdown, the dollar could be poised for more losses and more pain because the chance of taper this year would fall to zero.
We want to take this opportunity to remind investors that even if Congress fails to reach a compromise, the U.S. government has options -- one possibility would be for the President to invoke authority under the 14th Amendment and order the federal government to keep borrowing. Emergency times call for emergency measures and this was a strategy previously suggested by President Clinton during the budget showdown in 2011. Republicans would scream for an impeachment and the Supreme Court may have to vote on its legitimacy but this is a route that many Democratic leaders are urging the President to consider seriously. The U.S. government could also sell other assets such as gold or prioritize payment of bondholders over other obligations, but none of these options are as palatable as a clean increase to the debt limit.EUR Backs Off 1.36 As Dollar Recovers
For the first time this week, the euro traded lower against the U.S. dollar. The sell-off in the currency was caused primarily by dollar strength. Eurozone data was weaker than expected with producer prices in the region stagnating in the month of August but inflation is not a big concern for the ECB right now and therefore not a key market mover for the euro. Instead, some investors are dipping their toes back into the U.S. dollar and this demand drove the EUR/USD pair lower. The big news in Europe today was a subcommittee's recommendation that the Senate expel Berlusconi from Parliament. This is the first step to an official vote on expulsion later this month and given the recent political developments and the diminishing support for the former Prime Minister, there's a 90% chance that he will lose his seat. While this may finally bring Italy's political crisis to an end, it is the beginning of a long road for Berlusconi that could end with prison. He will no longer be subject to the same protections given to members of Parliament and could face charges on other pending cases. Troubles for Berlusconi means relief for the markets and one less risk for the euro. The Eurozone economic calendar is relatively quiet next week with only German trade and industrial production numbers scheduled for release.GBP Extends Losses As Positive Growth Surprises Fade The worst performing currency today was the British pound, which continued to be dogged by this week's weaker than expected economic reports. The U.K. economy is recovering nicely but the positive growth surprises are beginning to fade, leading investors to wonder if the rate of growth is slowing. Manufacturing, service and construction sector activity declined slightly in the month of September while prices grew at a slower pace. For the Bank of England who meets next week, these pullbacks will validate their concerns about the sustainability of the U.K. recovery. While many U.K. officials acknowledged the improvements, they have only been cautiously optimistic and made it clear to the market that they are a long ways from tightening. We agree that the central bank won't hike rates for at least another year but we also feel the U.K. economy will outperform and that the recent sell-off in sterling will be temporary. Aside from the BoE meeting, industrial production and the trade balance are on the docket next week along with speeches from BoE members Gracie and Haldane.
CAD: Shrugs Off Weaker-Than-Expected IVEY PMI Thanks to the rally in U.S. stocks and improvement in risk appetite, the Canadian, Australian and New Zealand dollars rebounded against the greenback. The commodity currencies shrugged off weaker data and decline in gold prices. According to the latest IVEY PMI report, manufacturing conditions in Canada expanded less than expected in the month of September. Economists had been looking for IVEY PMI to rise to 53.6 from 51 but instead, the index rose to only 51.90. Yet the CAD was unfazed and held onto its gains because of the sharp rise in employment. The jobs component of the report jumped from 43.6 to 53.5, a sign that Canada enjoyed another month of positive job growth. Yet despite the rally in the loonie, slower than expected growth in manufacturing is consistent with Bank of Canada Deputy Governor Macklem's warning this week that Canada could expand more slowly this year than previously forecasted. For the Canadian dollar, inconclusive data should keep USD/CAD confined in a 1.02 to 1.04 range. The AUD and NZD on the other hand appear poised for more gains on a technical basis but that will depend on the developments in Washington. At the start of the week, Australia will release its latest PMI Construction report but the piece of data that the market is most eager to see will be Thursday's employment report.JPY: Bank Of Japan Expresses Confidence In Monetary Policy
The Bank of Japan's decision to leave monetary policy unchanged had very little impact on the Yen. In his press conference, central bank governor Kuroda expressed comfort and confidence in the current level of monetary policy. He specifically mentioned the uptick in the Tankan survey and said their current policy should be enough to achieve their inflation target. He praised the government's decision to raise the consumption tax because maintaining trust in Japan's finances is crucial. This suggests that the BoJ is not worried about any economic drag from the tax which is a reasonable considering that the increase won't happen until April of next year. It would be smarter for the central bank to wait until December and see if corporate taxes are reduced before shifting their stance. Like his peers around the world, Kuroda also expressed concern about the U.S. fiscal crisis. We have heard many policymakers in other countries cry about the negative impact that a prolonged U.S. government shutdown could have on the financial markets and the global economy. As a result, the BoJ promised to take appropriate action if needed. Next week should be a relatively quiet one for Japan with the performance of the Yen dependent on risk appetite.

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