With the debt-ceiling deadline looming just days away, this is a crucial week in the financial markets, and based upon the price action in currencies, FX traders have nerves of steel. Another day has passed without Congress reaching an agreement to raise the debt ceiling or fund the government, yet US dollar (USD) losses have been limited.
While the greenback traded lower against most major currencies, the losses were small, and the dollar recovered from a steeper slide at the start of the North American session. The reversal seen in both currencies and equities was triggered by comments from President Obama, who said "important progress" had been made in the debt negotiations.
The Senate majority leader was also optimistic that a deal would be reached, but that only refers to a deal in the Senate, which would still have to be approved by the House. As a result, the US is still very much at risk of a disastrous and first-ever sovereign debt default, and it’s that looming event risk that speaks to the courage of traders who have kept hold of US dollars while the countdown clock keeps on ticking.
We have now entered the third week of the US government shutdown with not even a temporary solution imminent that would re-open the government and raise the debt ceiling. While investors are still hoping for an eleventh-hour deal, the risk of a default has grown substantially.
With a newfound aggressiveness among Democrats and Republicans clearly on the defensive, negotiations will go down to the wire, keeping investors uneasy for most of the week. However, the level of relative stability in the markets is a signal that the majority doesn't believe government officials will allow the first-ever debt default.
Regardless, risk premium is high, and for this reason, we don't expect any new positioning or breakout trends until the uncertainty is lifted, either by way of a six-week stop-gap funding measure, a clean increase to the debt ceiling, or a technical default.
Unless there is a sudden compromise before Thursday, October 17, we expect additional losses in USDJPY, further gains in EURUSD, a continued recovery in gold, and a steeper correction in US equities. The likely scenario is still for a last-minute deal, but unlike in 2011, when the debt ceiling was raised two days before the Treasury reached its borrowing limit, this time, a deal may not happen until the last few hours.
For more on what could happen to the dollar in the case of a US debt default, read our special report, Lesser-Known Facts About Trading the Debt Crisis.
Fed Taper Talk Is on Shutdown, too
As long as the US government remains shut down, most US economic data will be delayed, but there are a handful of reports including the Empire State and Philadelphia Fed manufacturing surveys, jobless claims, and the Federal Reserve Beige Book report that will be released on schedule.
A number of Fed presidents are also scheduled to speak, and we will be listening closely to see if the government shutdown and fiscal uncertainty has made them more reluctant to taper asset purchases this year.
It is very difficult for Fed officials to justify changing monetary policy when no data has been released for the past two weeks, and even if a resolution is passed, any data that were to be released in the weeks that follow would be distorted. As a result, we continue to believe that the Fed will maintain its current level of asset purchases for the rest of 2013.
While talks in Washington will dominate the headlines, US corporate earnings will also be in focus this week, with 20% of companies in the S&P 500 reporting in the days ahead.
A Surprise Beneficiary of a (Potential) US Debt Deal
The Japanese yen (JPY) ended Monday lower against the US dollar, but its performance against other currencies was mixed. This is a quiet week for Japan, with the most important release being the country's final industrial production report.
The lack of market-moving data means that JPY crosses will take their cues from risk appetite and US Treasuries. If Treasury yields continue to move lower on the growing risk of a US debt default, USDJPY could drop towards 97, taking all of the JPY crosses down with it.
Of course, if and when a compromise is reached in the US, JPY crosses will be among the biggest beneficiaries. As a result, traders should position accordingly depending on how much faith they have in the US government and its ability to compromise before time runs out.
Bank of Japan (BoJ) Governor Haruhiko Kuroda will also be speaking at the end of the week and we continue to expect the central bank head to express confidence in the current level of monetary policy.
By Kathy Lien of BK Asset Management