A temporary spending bill would eliminate the possibility for Fed tapering this year, and while the dollar and equities are cheering the news, gains are likely to be capped since the crisis will simply resurface in 6 weeks.
US assets are back in demand following reports that Republicans and Democrats are moving closer to passing a temporary spending bill that would fund the government and extend its borrowing limit until late November/early December.
For the past month, the financial markets have been held hostage by the US debt crisis, and investors are cheering the first signs of progress. However, the gains are not expected to last long because the government will just be kicking the can down the road further, leaving US debt troubles to cripple the markets again little more than a month from now.
The government is also expected to remain closed during the extension, so despite less-dovish Federal Open Market Committee (FOMC) meeting minutes released this morning, the Federal Reserve will not be able to taper asset purchases this year.
Each week the government remains shut down, US GDP growth is reduced by a minimum of 0.1%. Even if furloughed government workers receive back pay, the shutdown will still have a negative impact on consumer and business sentiment, and most notably spending.
Between the drag on the economy and this week’s nomination of Janet Yellen as new Federal Reserve Chairwoman, the chance that the central bank will taper asset purchases this year has dropped to almost zero.
The lack of reliable US data also makes the Fed's decision more difficult, which is another reason why we feel US dollar (USD) gains will be limited. Today, US jobless claims surged to 374k, up from 308k to reach the highest level since March, but according to the Bureau of Labor Statistics, the data was distorted by the recent computer upgrade and the dismissal of US government employees on account of the shutdown.
The delay in other economic reports and the distortion in jobless claims data mean no action is likely from the Fed in October, and if the government shutdown extends into December, the central bank won't have enough reliable information to taper asset purchases by the end of the year.
Nonetheless, equities are trading sharply higher, and the dollar is up against all major currencies because investors are focusing on today's progress. Ten-year Treasury yields also broke above 2.7% and hit the highest level in nearly three weeks.
With only seven days left before the US government is expected to run out of cash, according to Treasury Secretary Jack Lew, the best and only option for Congress at this stage is to kick the can down the road.
However, once today’s euphoria fades, the market should realize that delaying a resolution for six weeks means that fiscal troubles will remain a risk for the US economy and world financial markets until Thanksgiving. So while we may see a further relief rally in the dollar and US stocks this month, we expect the gains to be limited because parts of the government will remain shut down as the battle in Washington extends into November.
In other words, the problem has not been resolved, only pushed forward, extending the period of uncertainty for the US and global economies. At best, we expect no more than a 2% rally in the US dollar, with gains in USDJPY capped below the 100 level.
By Kathy Lien of BK Asset Management