Fiscal Gridlock Keeps Dollar Under Pressure

This is a crucial week in the financial markets and the losses in the dollar reflect the growing risk of a U.S. default. We are now entering the third week of the U.S. government shutdown and the House and Senate have not moved any closer to signing a stopgap agreement to reopen the government and raise the debt ceiling. Stocks are trading lower while bond markets are closed for the Columbus Day holiday but the sell-off in the dollar and equities are still restrained by the hope for an eleventh hour deal. Unfortunately the clock is ticking and with each passing day, the risk of a default increases exponentially. With a newfound aggressiveness in the Democratic Party and the Republicans on the defensive, negotiations will go down to the wire, keeping investors uneasy for most of the week. Unless there is a sudden compromise before Thursday October 17th, we expect additional losses in USD/JPY, further gains in the EUR/USD, recovery in gold and a steeper correction in stocks. Our base case scenario is still for a last minute deal but unlike 2011, when the debt ceiling was raised 2 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 if the U.S. Defaults, read our special report.

For as long as the U.S. government remains shutdown, U.S. data will be delayed but there are a handful of economic reports that will be released including the Empire State and Philadelphia Fed manufacturing surveys, jobless claims and the Federal Reserve's Beige Book report. A number of central bank 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 about tapering asset purchases this year. It is very difficult for Federal Reserve officials to justify changing monetary policy when no data has been released over the past 2 weeks and any data that will be released in the weeks that follow will be distorted. 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, as we wait for a resolution, U.S. earnings will also be in focus with 20% of companies in the S&P 500 reporting this week.

Right now, investors still have nerves of steel because they don't believe that the U.S. government will allow for its first ever default and this assumption is helping the markets a maintain a level of stability. However the risk premium is high and for this reason, we don't expect any new positioning or breakout trends until the uncertainty is lifted either through a 6 week stopgap funding measure, a clean increase to the debt ceiling or a default. As a result, currency traders should expect more consolidation in the front of the week with a spike in volatility at the end of the week.