The USD, Government Shutdown And Currency Wars

Some investors may still be digesting the implications of the Fed's decision to maintain its current pace of asset purchases but the market is beginning to move onto the debt ceiling debates, prospect of a government shutdown and currency wars. After selling off sharply post FOMC, the dollar has stabilized and even recovered strongly against the Japanese Yen today. Economic data was good, supporting Bernanke's thesis that if they keep the pedal to the metal, the recovery should solidify and gain momentum. The risk of a government shutdown is one of the main reasons why the central bank decided to keep policy steady.

For the past four months, the U.S. government has been using emergency measures to avoid breaching the $16.7 trillion debt ceiling and based on the current level of spending, the government could run out of cash by October 1, which could force a government shutdown in late September. The last time the U.S. government was officially shut down was 1995 to 1996. A standoff between Democrats and Republicans shuttered the government during the Clinton Administration for 5 days in November 1995 and then for 21 days between December 15 and January 6th. In both cases the Dollar Index dropped more than 0.65% before recovering quickly once federal offices were reopened. So FX traders shouldn't be overly concerned about a government shutdown because the impact on the dollar is expected to short-lived. According to Treasury Secretary Jack Lew Congress should not wait until the eleventh hour to raise the debt ceiling.

Meanwhile it should be no surprise that the actions of the Federal Reserve can have global repercussions. When Bernanke talked tapering in July, he drove global bond yields higher, creating a headache for other central banks. Now, their decision to delay a reduction in asset purchases can also pose a problem for central banks of countries such as Japan, Australia and New Zealand who may have been banking on U.S. dollar strength to ease pressure on their currencies. If currencies continue to strengthen versus the dollar, these central banks may have to offset the drag on the economy with easier monetary policies which some feel could plunge the world back into a currency war. We believe that the risk of a currency war heating up because the Fed decided not to taper is overblown because easy monetary policy should provide underlying support for the U.S. recovery, helping to boost the export activity of other nations. Furthermore, tapering is still inevitable and should occur within the next six months.

Manufacturing activity in the Philadelphia region expanded at its fastest pace since March 2011 while leading indicators rose 0.7% and existing home sales grew 1.7%. The country's current account deficit also narrowed to -$98.9 billion, its best level in 11 years. Jobless claims rose less than expected but the Labor Department said the data continues to be distorted because two states are still working through their backlog of applications after a computer upgrade. As all of these reports were better than expected, the dialogue about Fed tapering this year remains alive -- although at this stage a move in 2014 is more likely.

GBP Rally Stalled By Surprise Decline In Retail Sales Weaker-than-expected economic data made the British pound the worst performing currency today. To many people's surprise, U.K. consumer spending dropped 0.9% in the month of August. While the contraction in spending reported by the British Retail Consortium signaled that retail sales could be weak, few expected the largest decline in 10 months. The pullback in demand can be blamed on food sales, which soared in July but plunged in August. If consumer spending fails to recover significantly in September, retail sales could subtract from GDP growth in the third quarter. Considering that there are no major U.K. reports expected on Friday or scheduled for release next week, the decline in consumer spending could cap gains in sterling in the near term or at least limit its rise relative to other currencies. However if the PMI reports due the first week of October confirms that the recovery still underway, we could see renewed gains in the pound. Based on the Confederation of British Industry's Industrial Trends survey, manufacturing activity continued to improve in the month of September. Public Sector Finances are expected tomorrow and a major increase is forecasted for net borrowing.

EUR Extends Gains, SNB Upgrades GDP Forecast
The euro ended the day slightly higher against the U.S. dollar and with no euro zone economic data on the calendar, the move can be attributed entirely to U.S. dollar weakness. The only news from the region was the Italian Senate's decision to postpone its hearing on Berlusconi to October 4 and European Finance officials have tentatively approved a change in the region's budget rules to relieve pressure on debt ridden countries such as Spain and Portugal. The approval still needs to be confirmed by senior officials next week. The repeated delays shows how difficult the decision is politically and how much is at stake. The Senate fears that expelling Berlusconi could lead to collapse of the coalition government. Yet the delayed vote is good news for the euro because it removes a near term risk for the currency. European stocks are also at 5-year highs which supports the currency. The focus during the European trading session aside from the UK retail sales report was the Swiss National Bank's monetary policy decision. As expected the SNB left rates unchanged but it is worthwhile to note that they upgraded their 2013 GDP forecasts from 1.0-1.5% to 1.5-2.0%, which signals more optimism about the recovery. The central bank still feels that a EURCHF floor is necessary and pledged to continue to intervene in unlimited size to enforce this level but we are beginning to see the fruits of their labor. While Switzerland's trade surplus shrank in the month of August, exports grew 0.8%. The SNB expects more external demand in the second half of the year as the U.S. and Chinese economies recover which could lead to stronger gains in the Franc versus the euro.

NZD: 10 Days Of Uninterrupted Gains
The New Zealand dollar is on a tear. Today marks the tenth consecutive trading day the currency has either held steady or extended higher against the U.S. dollar. This uninterrupted rally highlights the importance of monetary policy direction in the movements of currencies. The Fed's decision to maintain its current level of asset purchases should have driven all other major currencies higher but the only currency that has reacted accordingly is the New Zealand dollar. The reason for its outperformance is simple -- the RBNZ said they are planning to raise rates in 2014, a hawkish bias that sets them significantly apart from all of its peers. Economic data has also been good, supporting the case for tightening. Last night, we learned that New Zealand's economy grew 0.2% in the second quarter. While this was a slower pace than Q1, on an annualized basis, GDP growth hit 2.5%, which was stronger than anticipated and would have been hotter than Q2 if not for the significant upgrade in the first quarter. If data continues to be firm, the RBNZ could be first major central bank to raise interest rates. The rally in the NZD/USD may be overextended and a correction to 82 cents is not impossible but we would view any pullback as an opportunity to buy at lower levels for a move to 86 cents. The Australian and Canadian dollars on the other hand failed to extend their gains. No economic data was released from Australia but wholesale sales in Canada rose 1.5% in July after falling 3.1% in June - this bodes well for the more closely followed retail sales report. New Zealand credit card spending and Canadian consumer prices are the only pieces of data expected from the commodity producing countries over the next 24 hours.

Behind The Recovery In USD/JPY
Investors sold dollars aggressively on Wednesday but less than 24 hours after the Federal Reserve decided not to taper asset purchases the greenback recovered all of its losses against the Japanese Yen. The rapid-fire recovery in USD/JPY may have caught some traders by surprise but new highs in the Nikkei helped to lift all Yen pairs and the prospect of more stimulus from the Bank of Japan is contributing to the move. BoJ member Kiuchi said the central bank could be influenced by external factors such as market expectations and will be forced to respond in such a way. In other words, if investors are looking for more stimulus to offset the impact of a consumption tax, the BoJ may be forced to deliver. Last night's Japanese economic reports were better than expected with the country's trade deficit narrowing and the all industry activity index ticking higher Japan's trade deficit was Y960B in the month of August, up from Y1.028 trillion in July. Exports rose for the sixth straight month by 14.7% thanks to stronger demand from the U.S. and China. Despite the volatility in the Yen, the pickup in the export sector is good news for Japan's economy. Nationwide department store sales and the Ministry of Finance's weekly portfolio flow data is scheduled for release this evening.

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